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Thursday, May 21, 2009

John Vachon Cherries of Wrath July 1940Migrant fruit workers from Arkansas, Berrien County, Michigan

Ilargi: Britain is the first major industrial nation under the threat of an across the board downgrade of its credit rating, with Japan hot on its heels and the US not far behind. While these are truly serious developments, and things look deeply alarming for Britain, there’ll still be a lot of water under the bridge before the whips and chips come down. One rating agency, in Britain's case Standard & Poor's, can raise a warning, but that doesn't mean it will act on it, or even intend to. And one agency can't kill a rating, it would take Moody's -and maybe also Fitch- to chime in before things get real point of no return ugly.

The actions from these three largest agencies over the past few years indicate they have mostly lost their grip on reality, so they'll be very hesitant to act decisively. I think it would be very interesting to see Sean Egan at Egan-Jones brought to the front to share his views, along perhaps with Canada's DBRS, which also has a US license. There are so many variables in these equations that it's downright presumptuous to make much of a prediction. That said, there are plenty countries that are about to break through, or already have, S&P's limit of a 100% debt-to-GDP ratio. And let’s be real, ratings will eventually come down for all three countries and many more, and that mass event, ironically, may well come to their rescue for a while. For a while only, though: it''s that suspended in mid air in no place special notion revisited, and again.

What they all need is a very substantial recovery in their economies, and most of all in international trade, since that's basically the only venue available to bring down those behemoth debts without resorting to debasing their currencies. And of course there lyeth the problem: every single country which has a central bank that issues a fiat currency and charges interest for doing so (think the entire western world) needs a trade surplus at least equal to that interest rate just to play even. It's temporarily different for the US because of the dollar’s reserve currency status, but that won't last much longer, and just think where it would be if it were in the same situation as the other nations, needing a 5-6% surplus simply not to get poorer. That should give you an idea of how poorly the US is really doing. No laughing matter.

Still, leaving all the background thoughts behind for a moment, there is no imminent danger of default for any major nation, no singularity or any of those ill-chosen terms. One of the main reasons for which is that federal governments can and will transfer their problems to the lower levels of government within their jurisdiction. There will be bond dislocations on the corporate, county, state, provincial and municipal level way before major nations' credit fails, simply because a federal government has the power to gobble up all that's on the table, plus the crumbs that have fallen off. There may be many plates, and many guests expecting to be fed, but if there's not enough food, the host will still eat to his fill.

So no big blow-up moment, it will not happen, certainly not in the US, even though we will see smaller nations follow Iceland into a deep freeze, and then fall deeper. Iceland will soon be looked upon as one of the luckiest places on earth. First in line, small enough to repair, that sometimes works fine. Not in great shape, but much better than most.

What will indeed happen can best be described as erosion. It may move pretty fast, but in the beginning it will be destructive only locally, in communities that can no longer issue debt because the federal government won't let them. The California government recently threatened exactly that: to take property tax revenues away from lower governments in order to fill the holes in its own budget. We’ll see lots of that, in many shapes and forms.

Come the end of summer, many if not most bets are off, and we will see a lot of defaults and misery, some in expected, others in completely unforeseen places. But the demise of credit ratings for entire major industrial nations is far too early a call: they simply have many resources that are as yet untapped, if only it's your property taxes, sales taxes, whatever it takes, that now run your towns. Illegal, you say? Who makes the law?

In the fall of 2009, there'll be no more green shoots. They'll be needed just to feed people. And the big fall will start, for sure. But for the main implosions of whole nations, you’ll have to wait till next year. Just as well.

Homeowners nationwide with good credit but artificially low mortgage payments could be forced to pay more to the bank sometime within the next three years, according to Credit Suisse. If low interest rates remain, some of these borrowers will be spared payment shock. But those with extremely low payments via deferral of interest/principal owed, will not. While preparing a story about high-priced foreclosure resales selling slowly in Orange County, I asked Credit Suisse for the latest version of its chart on loan resets nationwide. [Here] is the version updated last month.

It shows resets increasing from here with peaks in 2010 and 2011/2012 in the range of $30 to $45 billion monthly. The chart also shows subprime resets are still going on, but decreasing in frequency over the rest of 2009. However, prime resets and resets on loans to people with decent credit scores but special circumstances (stated income) are heading straight up through early 2012. Note that the chart uses both resets, when interest rates change, and recasts, when payments change. Resets and recasts often happen at once, but not always.

Credit Suisse, an analyst told me, used resets in the chart for all loans except option adjustable-rate mortgages, when borrowers can choose a minimum payment that may be less than interest owed (option ARMs are in yellow on the chart… see how they are rising!). For option ARMs it used recasts, which can happen either when the loan amount expands to a maximum allowed — often 115% or 125% of original principal — or a set period, such as five years. Now here is a copy of the chart published in a February report:

This chart goes back further in time. The older chart shows a big peak in 2010 — about $40 to $45 billion a month in loans around September/October 2010. The newer chart pushes that peak about one year into the future into late 2011/beginning 2012. Some borrowers will hold on a little longer. Maybe the housing market will recover by 2012 and they can sell to avoid foreclosure. But if any of these borrowers are deferring principal and interest owed, reaching say a maximum of 125% on a loan amount on 2005 to 2007 prices, then it is much less likely home prices will have rebounded enough to save them by 2011 or 2012.

US Commercial real estate prices as measured by Moody’s/REAL Commercial Property Price Indices (CPPI) fell 1.7% in March, leaving the index at 20.8% below its level a year ago and 22.8% below the peak in prices measured in October 2007. Commercial real estate sales volumes were down 75-80% in March, by both count and dollar volume, compared to their levels a year earlier. Moody’s expects continued weakness and possibly further declines in volume in the coming months. Moody’s quarterly indices by property type show national office prices have now fallen 30% from peak levels, after a nearly 20% decline in the first quarter. National retail properties saw values fall 13% in the first quarter, while apartment and industrial prices remained relatively flat.

Among the top-ten metropolitan statistical areas (MSAs), retail was the underperformer, with prices falling 14% in the first quarter of 2009. Western apartment prices saw a slight gain in the first quarter of 2.7%. Office was the hardest hit property type in the West with values falling over 16% in the first quarter, the single largest drop to date for this sector. Moody’s notes that so far this downturn, the top-ten markets have not seen prices fall as much as the nation has overall. Office prices in the top-ten, for example are down 14.3% from their peak, compared to the 30% decline nationally.

The number of newly laid-off workers requesting unemployment insurance dropped slightly last week after spiking due to auto layoffs, while continuing jobless claims inched closer to 7 million. The Labor Department said Thursday that initial claims for jobless benefits fell to a seasonally adjusted 631,000, down from a revised figure of 643,000 the previous week. That nearly matched analysts' expectations of 630,000 new claims. Claims jumped two weeks ago as Chrysler LLC shut its factories after filing for bankruptcy protection April 30, putting up to 27,000 hourly employees out of work. Wall Street economists expect factory shutdowns by Chrysler and General Motors Corp. to inflate the initial claims numbers through June.

The number of people continuing to claim unemployment insurance rose to nearly 6.7 million from about 6.6 million, the department said, also close to analysts' expectations. That's the highest total on records dating to 1967 and the 16th straight record. The data reinforced the notion that while the overall economy may start to pick up later this year, the labor market likely will remain weak into 2010 and beyond. As a proportion of the work force, the total jobless benefit rolls are the highest since December 1982, when the economy was emerging from a severe recession. The numbers indicate that laid-off workers are having a difficult time finding new jobs. The continuing claims data lags initial claims by one week. The four-week average of new claims, which smooths fluctuations, dipped to 628,500, from 632,000, the department said.

Claims had reached a 14-week low of 605,000 earlier this month, from 674,000 in late March, the peak for the current recession. Many economists had seen the drop as a sign that layoffs were easing and the economy could be nearing a bottom. The auto shutdowns have interrupted that decline, though economists expect the downward trend in new claims to continue once the impact of the auto layoffs has passed. The Federal Reserve, meanwhile, expects the economy will start to grow again later this year, according to documents released Wednesday. But Fed officials expect the unemployment rate, currently at 8.9 percent, could rise to 9.6 percent this year and remain elevated until 2011. Some private economists expect the rate to reach 10 percent by the end of this year.

More job cuts have been announced this week. American Express Co. said it will cut about 4,000 jobs, while Medtronic Inc. said it would eliminate up to 1,800 positions and Hewlett-Packard Co. said it would cut 6,400 jobs.Among the states, Michigan had the largest increase in claims for the week ending May 9. Claims there rose by 16,817, which it attributed to layoffs in the auto industry. The next largest increases were in North Carolina, Virginia, Kentucky and Pennsylvania. California reported the largest decrease in claims of 10,052, which it said was due to fewer layoffs in the service industry. The next largest decreases were in Wisconsin, Kansas, Oklahoma and Washington.

Sterling fell sharply today after credit ratings agency Standard & Poor's cut its outlook for the UK on fears over ballooning levels of Government debt. The world's biggest ratings agency declared that there is a one in three chance of Britain losing its coveted AAA status. The pound crashed to as low as $1.5514 against the US dollar in the minutes after S&P's shock declaration at 9.30am, having earlier traded at a six-month high of $1.5817. It fell against a host of other currencies as investors ran for cover after S&P lowered its outlook for the UK from "stable" to "negative". Chris Turner, head of FX strategy at ING, said: "Today's outlook change suggests sterling will require an extra risk premium over coming quarters and may rein in some of those more-bullish calls for sterling-dollar."

Geoffrey Yu, currency analyst at UBS in London, said: "This was really unexpected, and there are several risks involved. "Some countries hold sterling as a reserve currency, albeit small, so there could be massive selling of that, as well as concerns about debt servicing given Britain is highly leveraged and depends on foreign financing." S&P maintained the UK's AAA rating but warned it could be cut if the public finances continue to deteriorate. It warned that Government debt could hit 100% of gross domestic product by 2013 and "remain near that level thereafter". It is currently at 53.2% of GDP and rising. Rival agency Moody's said the outlook for its UK sovereign rating was stable and not under review.

"While the UK economy and public finances face considerable challenges, the Government has both enough balance-sheet flexibility to absorb the shock and the capacity to reverse the damage over time," it said. Gilt prices also came under pressure following the shock downgrade but it did not disrupt the gilt auction just a couple of hours later. Chancellor Alistair Darling said the success of the auction, in which £5 billion of five-year bonds were sold, showed the confidence investors have in the UK economy. City economists were less bullish, however. "The threat of a downgrade has been an accident waiting to happen given the poor state of the public finances and this year's Budget which failed to address the problems," said Philip Shaw, chief UK economist at Investec.

Kenneth Broux at Lloyds TSB Corporate Markets said it was "a reality check for the UK government". Sentiment was dealt a further blow when the Federal Reserve cut its forecast for the US economy and former Fed chairman Alan Greenspan said banks are still in peril. The Fed said there were "significant downside risks" to the economy and the global financial system was still "vulnerable to further shocks". Greenspan warned US banks will need to raise "large" amounts of money and "we still have a very serious potential mortgage crisis".

The unified rating of Aa2 reflects Japan's considerable strengths. These include Japan's large domestic savings, a strong home bias on the part of its domestic financial institutions and institutional investors, relatively low holdings of government debt by foreign investors, and Japan's $1 trillion of official foreign exchange holdings. Moody's believes the domestic market will absorb the record level of bond issuance this year to fund the government's economic stimulus program.

However, the rating also reflects the risks of Japan's high level of debt, which leaves the country's fiscal position vulnerable to shocks or imbalances that would cause a sharp rise in interest rates. The ratings also reflect the sizable but temporary increase in the government's budget deficit caused by the severe effects of the global collapse in trade and recession on the Japan's economy. Further, Japan's large foreign exchange reserves, although large compared to those of most other countries, are only a small fraction of its liabilities and could not alone eliminate refinancing risk at a time of severe stress."

That net debt number is likely to exceed 100% of GDP in 2009. Moody's noted that very little of this debt is held by non-Japanese. Of course, one of the primary causes of this is the fact that much of this debt was issued at extremely low interest rates. So it was relatively unattractive to foreign investors. Japan's government debt amounts to the country's citizens avoiding taxation now with the expectation that the country's future productivity will be great enough support repayment of the debt in the future without ruinous taxation levels.

The Bank of Japan holds over $600 billion in US Treasury debt. In theory, the proceeds from these holdings as they mature could be used to reduce the outstanding domestic debt over time. Of course, that would put upward pressure on the yen versus the dollar and thereby weaken the country's export sector. The decision that faces Japan's leadership today is whether to continue to depend on exports, or shift policy to supporting the domestic sector more and thereby increasing the proportion of GDP generated domestically. Such a shift would result in short term difficulties, but in the long run would serve the Japanese public best.

Other weaknesses of Japan include the fact that it has no meaningful defense forces, and its agricultural sector cannot produce enough to feed the country's population for any meaningful length of time. Also, Japan relies on imported fuels for over 80% of it's energy needs.

Another issue is that somehow the fact that Japan has been running inflationary policies for 18 years now is easy to miss when their nominal numbers all are so flat. It was easy to see the inflation get exported to the US and the rest of the world through the carry trade mechanism. The question that doesn't seem to be asked is where all of those yen went after the carry trades were unwound. At some point the BoJ has to remove the excess yen, which would obviously be deflationary, or we should expect a collapse in the yen.

Bill Gross, the co-chief investment officer of bond giant Pacific Investment Management Co., said market fears that the U.S. is at risk of losing its AAA credit rating is sending the U.S. dollar, stocks and bonds under severe selling pressure on Thursday. Asked what is driving the market declines, Gross told Reuters via email that investors fear the U.S. is "going the way of the U.K. -- losing AAA rating which affects all financial assets and the dollar." Thursday, Standard & Poor's lowered its outlook on Britain to "negative" from "stable," threatening the nation's top AAA rating. Britain faces a one in three chance of a ratings cut as debt approaches 100 percent of gross domestic product.

European shares fell, weighed down by banks and commodities, as S&P's potential UK credit cut added to worries sparked by news on Wednesday that Federal Reserve policy-makers had cut their U.S. growth forecasts over the next three years. The pan-European FTSEurofirst 300 index of top shares fell 2.1 percent to 857.52 points, breaking five successive sessions of gains. U.S. equities were down as well. The Dow Jones industrial average was down 182.55 points, or 2.17 percent, at 8,239.49. The Standard & Poor's 500 Index was down 21.26 points, or 2.35 percent, at 882.21. The Nasdaq Composite Index was down 44.89 points, or 2.60 percent, at 1,682.95.

U.S. Treasury debt prices moved in sympathy with equities. The benchmark 10-year U.S. Treasury note fell 47/32, with the yield at 3.3625 percent. The 2-year U.S. Treasury note dropped 2/32, with the yield at 0.8587 percent. The 30-year U.S. Treasury bond plunged 91/32, with the yield at 4.3106 percent. In currencies, the dollar was down against a basket of major trading-partner currencies, with the U.S. Dollar Index down 1.01 percent at 80.369 from a previous session close of 81.190. The dollar extended losses against the yen on Thursday, dipping below 94 yen for the first time in two months.

The U.S. dollar's day of reckoning may be inching closer as its status as a safe-haven currency fades with every uptick in stocks and commodities and its potential risks - debt and inflation - are brought under a harsher spotlight. Ashraf Laidi, chief market strategist at CMC Markets, said Wednesday a "serious case of dollar damage" was underway. "We long warned about the day of reckoning for the dollar emerging at the next economic recovery," Mr. Laidi said in a note. Mr. Laidi said economic recovery would weigh on the greenback as real demand for commodities, coupled with improved risk appetite, caused investors to seek higher yields in emerging markets and commodity currencies.

This would draw investment away from the U.S. dollar, which was dragged down by growing debt and the risk quantitative easing would eventually spark a surge in inflation. The U.S. dollar slid against most major currencies Wednesday, hitting a five-month low of US$1.3775 against the euro and pushing the Canadian dollar up US1.21¢ to a seven-month high of US87.69¢. John Curran, the senior corporate dealer at Canadian Forex, said the U.S. dollar would likely fall further in the next week, with the Canadian dollar likely reaching about US88.35¢, at which point it could break higher to test the US92.35¢ level. "The U.S. dollar is continuing to slide as investor appetite is gaining momentum," Mr. Curran said. "People are getting comfortable about taking on a little more risk."

The rise in the Canadian dollar has moved in lock-step with the improvement in equity markets since March 9. Over this time, the S&P 500 has risen by 34%, the S&P/TSX composite index has gained 35% and the Canadian dollar has increased by 14%, equal to almost US11¢. Since Feb. 18, light-crude oil has risen by 46% to US$62.12. But as risk appetite and equities improve, Mr. Curran said it was unlikely the U.S. dollar would embark on a long-term decline. "While things are beginning to thaw, it doesn't mean it's full-on summertime just yet," he said. "A lot of people are looking for the Canadian dollar to strengthen dramatically again towards par. I'm not sure about that just yet."

Nevertheless, concern has been mounting that the increasing U.S. debt load, as well as a potential inflation time bomb in the form of the quantitative easing, could drag down the greenback. Garnering attention is the risk the United States could lose its triple-A sovereign credit rating, which reflects the chance of the borrower defaulting on its debt. "By many measures, the U.S. appears just a few short steps away from losing its coveted triple-A status, unless the recovery turns out to be considerably stronger than expected and the fiscal repair is faster than commonly expected," said Douglas Porter, deputy chief economist at BMO Capital Markets. "A downgrade could boost the cost of funding U.S. debt at the margin, but underlying inflation and fiscal fundamentals will ultimately be the primary driver."

Despite the risk, Paul Ashworth, chief economist at Capital Economics, said the United States was unlikely to lose its rating. But, in the event of a downgrade, he said it would probably not have a lasting impact on the U.S. dollar. However, he said a big threat lurked in the country's expanded monetary base, which now stands at about US$1.8-trillion. While the expanded monetary base was needed to feed economic growth and ward off deflation under the Fed's quantitative easing plan, Mr. Ashworth said such high levels could fuel rampant inflation once broader monetary conditions improved. He said it remained to be seen how much success the Fed will have when it decides to end its quantitative-easing plan and shrink the monetary bas

The US dollar fell to its lowest level of the year on Wednesday as Tim Geithner hailed signs of healing in financial markets and minutes showed the Federal Reserve had seen indications of economic stabilisation at its April policy meeting. Traders said the decline in the US currency was associated with hopes of financial and economic recovery. Such expectations are encouraging investors to buy riskier assets and abandon risk-aversion strategies that favoured US Treasury bills. Mr Geithner, US Treasury secretary, said there were "important indications that our financial system is starting to heal" – citing declining corporate bond yields and other market measures of financial stress.

The Fed released minutes that said "some signs pointing towards economic stabilisation were seen in data on consumer spending, housing and factory orders" – although the US central bank retained a cautious view on recovery, and increased its forecasts for unemployment. An index measuring the strength of the dollar against six leading currencies closed at its lowest level of the year. The dollar’s retreat gathered pace after the Fed minutes showed some policymakers had raised the prospect that the central bank might extend its asset purchases to boost the recovery. Such purchases would be made by creating money. As the dollar fell, oil gained nearly $2 to close above $62 a barrel – its highest level since November – while gold hit an eight-week high.

Alan Ruskin, a strategist at RBS Securities said: "People are re-examining basic trades as part of the risk recovery story and it makes sense that money should flow towards higher-yielding assets and beyond the US."Some economists worry that the current phase of the crisis – in which panic is receding but economic weaknesses remain severe – could test the ability of the US to attract external finance. At the peak of the crisis in late 2008, the US dollar and US government securities were buoyed by defensive buying by fearful investors around the world. Now, there is a less automatic bid for dollars and US government debt, forcing the US to compete for global capital.

Mr Geithner, meanwhile, expressed concern that "a lot of banks" had withdrawn their applications for a government capital injection from the troubled assets relief programme. Facing sometimes hostile questions at a Senate banking committee hearing, Mr Geithner said smaller banks felt the "capital is stigmatised with so many conditions that it will make it hard for them to run their business". "We need to try to counteract that because the insurance this capital provides is not valuable unless people are willing to come [and] take it," he said. Some of the initial recipients of the bail-out money, such as Goldman Sachs and JPMorgan, are keen to repay the billions of dollars in ?federal funds, in part to escape government restrictions on their operations.

The Treasury is keen that thousands of smaller institutions use the fund to strengthen their capital base and, in turn, extend loans to businesses to kickstart the economy.Mr Geithner reiterated that the government lacked the powers to wind up a financial institution such as AIG, the insurer, although these would come as part of a broader regulatory overhaul.We have no option now to selectively diminish the value of those claims without taking risk," said Mr Geithner. "I don’t believe that the system today can withstand the effects of a failure of this institution to meet its obligations. I wish it were not the case; nothing would make me happier." The House financial services committee starts hearings on financial regulation in June, including considering how to reform supervision of consumer products.

One proposal is for an agency to regulate such products, people familiar with the ?proposals said. Such an agency, if created, would take on the responsibilities from the Fed and Securities and Exchange Commission.Republican senators at Wednesday’s hearing bemoaned the "black hole" of AIG, the insurance company and recipient of more than $170bn of government funds, and hit out at the "politically motivated" restructuring of carmaker General Motors. The carmaker is likely to file for bankruptcy protection within a fortnight with creditors reluctant to accept a government-sponsored deal that offers more equity to a union healthcare fund than to bondholders.

"You can’t feel more strongly than me about the need to get the government out of this company," added Mr Geithner. However, he indicated that the US would still be involved in a year’s time.Richard Shelby, the leading Republican on the committee, said the Treasury needed to have a plan to unwind the unprecedented intervention in the market by the government and the Federal Reserve. "Doing that carefully and well will be one of the most important things facing us," said Mr Geithner, but he added that it was not the moment to set out the "exit strategy". Withdrawing support too early would be one of the gravest risks. "Crises don’t burn themselves out," he said.

Treasurys added to losses Thursday afternoon, reversing gains in the early-morning session and pushing the 10-year note's yield closer to the strongest level since November. Selling pressure mounted as the warning from Standard & Poor's on the negative outlook for the U.K. government's credit ratings caused a brief rout in U.K. government debt and the British pound. The concern is that the U.S., like the U.K., may risk a downgrade of its triple-A credit ratings as fiscal deficits widen and the amount of public debt swells. U.S. stocks and bonds and the U.S. dollar were down for the day. Bonds were also down on the announcement of a $101 billion government note and bond supply for next week, disappointment on the size of the latest round of bond purchases from the Federal Reserve and profit-taking ahead of a shortened session Friday before Monday's Memorial Day holiday.

"The Treasury market is fragile and jittery on a number of fronts," said Kevin Giddis, head of fixed-income sales, trading and research in Memphis, Tennessee, at Morgan Keegan Inc. "Some traders are planning on taking Friday off since it is a short day. [Trading volume] is fairly thin, so any moves up or down are magnified." The 10-year note's yield touched an intraday high of 3.381%, close to the 3.383% level hit on May 8, which is the strongest level since November. In recent trading, the two-year note's price was down 1/32 at 100 1/32 to yield 0.86%, while the 10-year note was down 1 10/32 at 98 1/32 to yield 3.36%. The 30-year bond was down 2 17/32 at 99 to yield 4.31%. Bond yields move inversely to prices.

The two-year note suffered the least along the curve as its yield is well-anchored by the 0% to 0.25% range for the fed-funds target rate, leaving longer-dated maturities at the mercy of the selling Thursday. Many investors took advantage of this discrepancy to pile into the so-called steepening yield-curve trade, by selling long-dated maturities and buying the two-year notes. The trade Thursday pushed the yield spread between the two-year note and the 10-year note to the widest level seen since November. The so-called benchmark yield curve touched 250 basis points Thursday, approaching the 261.9 basis points seen on Nov. 13, the widest since the historic peak of 274.7 basis points on Aug. 13, 2003.

Chris Bury, co-head of rates trading and sales in New York at Jefferies & Co., said the benchmark curve may touch the 260-basis-point level in the next few weeks. Treasury note and bond sales will resume next week after a two-week hiatus. The government announced Thursday that it will sell $101 billion, including $40 billion for a two-year note, $35 billion for a five-year note and $26 billion for a seven-year note, next week. Auctions of three-, 10- and 30-year securities will be up a week after.

Steep declines in the economies of three of the U.S.'s biggest trading partners -- Mexico, Japan and Germany -- underscored the severity of the global recession and put pressure on major industrialized nations to revive moribund global trade talks. On Wednesday, Mexico became the latest country to report a plunge in output. The country's gross domestic product fell at an annualized rate of 21.5% in the first quarter, the worst performance since the 1995 peso crisis led to an International Monetary Fund and U.S. Treasury financial rescue. This time, Mexico has insulated itself somewhat by arranging a $47 billion IMF credit line in advance. Mexico's decline followed by a day Japan's report that its economy contracted in the first quarter at a 15.2% clip, its worst performance since 1955. Last week, Germany said its first quarter decline in GDP, an annualized 14.4%, was the worst since 1970.

All three countries depend on exports to the U.S. But they have nose-dived as U.S. consumers cut back purchases of autos, electronics and other goods mass produced abroad. For the first three months of 2009, U.S. merchandise imports declined about 30% to $352.5 billion compared with the same period a year earlier. Mexico's ties to the U.S. are particularly strong because of the North American Free Trade Agreement, and Mexican auto production in the first quarter fell 41% from the year before. Most forecasters and governments see signs that the current quarter will be better than the first, and the rise in global stock markets suggests investors believe the worst is past. Still, the decline in output overseas reduces the market for U.S. exports and opportunities for investment.

The U.S. economy contracted at a 6.3% annual rate in the first quarter. Federal Reserve officials said Wednesday that they anticipate only "a gradual recovery," beginning in the second half of this year. They foresee unemployment, now at 8.9%, will rise above 9% and stay there through 2010. The recession's depth is bound to increase pressure to revive the stalled Doha Round of trade talks. Germany intends to raise the issue when leaders of industrialized nations meet in July.

Federal regulators seized the troubled Florida thrift BankUnited FSB on Thursday, a failure the Federal Deposit Insurance Corp. estimates will cost its insurance fund $4.9 billion. BankUnited is the second costliest bank failure of the recent banking crisis, trumped only by IndyMac, which officials believe will cost the FDIC close to $11 billion. Review the details on the banks that have been shut down by federal regulators since the start of 2008. BankUnited had $12.8 billion of assets and $8.6 billion in deposits.

Regulators said BankUnited was critically undercapitalized. The FDIC sold the banking operations to a management team headed by John Kanas, the former head of North Fork Bank. The bank's 85 branches will reopen Friday during normal business hours. Mr. Kanas's team will acquire $12.7 billion of BankUnited's assets and $8.3 billion in nonbrokered deposits. The FDIC and the new bank agreed to share future losses on roughly $10.7 billion in assets under the agreement. The new management also agreed to recapitalize the bank with $900 million in new money.

Sure, seeing your economy shrink at a 15 percent annual clip is depressing, quite literally, but if you believe in even a tepid global economic recovery in the second half, then Japan is actually attractive. There is no way to sugar coat the first quarter Japanese gross domestic product figures released on Wednesday: they are breathtakingly bad viewed from virtually any angle. The economy shrank by a record four percent in the quarter, or an annualized fall of 15.2 percent, leaving the economy no bigger in real terms than it was in 2003. Net exports fell sharply, by themselves pushing GDP 1.4 percent lower and, perhaps even worse, capital spending shrank by more than ten percent and private consumption fell by 1.1 percent.

What's more, stocks of inventory remain high when compared to sales, so there is plenty left to sell without placing new orders. But just as global trade, and with it Japan's economy, had an extended and sudden plunge in the wake of last year's panic, there are signs already of an improvement. Industrial production in March in Japan actually rose from the month before, up 1.6 percent, a rise echoed softly in the Reuters Tankan survey of confidence among manufacturers which showed less gloom than the month before. A recovery will require a substantial recovery in exports, industrial output and household spending, according to Julian Jessop, chief international economist at Capital Economics in London. 'The strong rebound in the survey evidence confirms that this is realistic,' Jessop wrote in a note to clients. 'The extent of the previous declines in exports and investment also leaves plenty of room for a decent bounce.'

That decent bounce could result in a nice return on Japanese shares, which have rallied in sympathy with global stocks. Significantly, Tokyo shares actually rallied after the GDP news even despite a rise in the yen which crimped the competitiveness of exporters. And measured on a price-to-book value basis, Japanese shares, especially smaller cap issues, are among the world's cheapest, implying decent potential for gains if the economy as a whole surprises. Japanese shares as a whole are trading on a one year prospective price-earnings ratio of about 30. Japan's economy is very highly leveraged to global trade, making this perhaps the key call in any bet on a recovery there.

Japan's position is better than it might seem because those things which it does still successfully export are of high quality and technical specification and less vulnerable to cheaper substitutes from China or elsewhere. A Barclays Capital composite leading indictor for Japanese exports, which tends to be three to five months ahead, has recently turned positive after a sustained and precipitous drop. The index includes U.S. stock prices, commodity prices, new orders in the U.S. in both transport machinery and information technology, Chinese auto production and the relationship between U.S. inventories and sales.

Efforts by China to jump start auto sales seem to have worked particularly well, recording an 18.5 percent gain in April from the year before. Similarly, there is a reasonably good chance we are in the midst of a U.S. recovery of some sort, though the risks are it is short lived or chronically feeble. As this happens look for a rebound in exports and production in Japan and even, at some point, in actual investment. This leaves us with the 20-year running sore that is Japanese domestic consumption. The fear, and it is not a small one, is that employment and income suffer after a downturn of depression size and that already falling consumption retracts further. The gap between Japan's output and its capacity is eight or nine percent now, making the risk of deflation, and with it the possibility of a negative spiral in spending, quite high.

Balancing that is the fact that Japan's healthy savings rate gives its consumers an option less available to their U.S. peers when income falls, they can make up some of the shortfall by simply saving less.Further, Japan is feeling the impact of a substantial fiscal stimulus, with at least some of the tax cuts finding their way into shopkeepers' hands. Japan also has front loaded infrastructure spending. As with all such spending, the impact of this is transient and, with the possibility of an election soon, there is no guarantee that further extra budgets will be forthcoming. It won't be glamorous, in part because the engine of growth will be elsewhere, but between now and the end of the year a rebound could be surprising and, depression-era style economic statistics notwithstanding, surprisingly profitable.

Now that key measures like the VIX and LIBOR are back to their pre-crisis levels, a clear picture has emerged of bank winners and losers. We set a basket of 7 major financial institutions to 100 in the days just prior to the Bear Stearns collapse. As you can see, the genuinely solid ones are all climbing back to their pre-Bear levels. The truly sick ones aren't even close.

Ed Liddy, AIG’s government-appointed chairman and chief executive, is to leave the stricken insurance giant after just eight months in the job, the company said o Thursday. AIG, which is 80-per-cent owned by the government, said it would split the roles of chairman and chief executive. Mr Liddy was plucked out of retirement by Hank Paulson, the former US Treasury secretary, last September to become chief executive of AIG. He was tasked with rebuilding the US insurance behemoth after the near-death experience that forced the government to bail it out. Pushed to the brink of bankruptcy by reckless bets on mortgage derivatives, AIG had lost two CEOs in rapid succession before Mr Paulson decided on Mr Liddy.

Treasury Secretary Timothy Geithner said the U.S.’s $700 billion financial rescue package can’t be used to aid cities and states facing budget crises. The law "does not appear to us to provide a viable way of responding to that challenge," Geithner told a House Appropriations subcommittee in Washington today. Among the hurdles: Money from the Troubled Asset Relief Program is reserved for financial companies, he said. The Treasury chief said he will work with Congress to help states such as California that have been battered by the credit crunch and are struggling to arrange backing for municipal bonds and short-term debt. The municipal bond markets are "starting to find some new balance and equilibrium," Geithner said.

Still, mayors and governors must get deficits down so their cities and states can raise their own funds, Geithner said. The federal government "may be able to help in some ways, but they are going to carry the primary burden," he said of the state and local officials. When asked whether he could "categorically" rule out assistance to California or other states facing budget problems, Geithner responded by citing the administration’s broad efforts to help the economy heal. "We will have to do exceptional things, as we have done already, to fix this mess," he said. "That’s not putting on the table, or taking off the table, any specific thing." Geithner also said he is "examining the merits" of setting up an independent agency or commission to regulate consumer-oriented financial products. He told the lawmakers that no final decision has been made and that the Treasury will unveil its plan in the next few weeks.

In his testimony, Geithner urged major economies around the world to take steps to repair their financial systems, saying the integration of global markets requires countries to work together to boost growth."Recovery here depends on recovery abroad," Geithner said. "Our financial reform effort in the United States must be matched by similarly strong efforts elsewhere in order to succeed." Representative David Obey, chairman of the Appropriations Committee, said he was "very, very reluctant" to approve more funding for the International Monetary Fund because some European countries have been too "modest" in their stimulus plans. "We don’t want Uncle Sam to be Uncle Sucker," said Obey, a Wisconsin Democrat. In response, Geithner said European efforts have been "better than you think," though he added that they must be "sustained."

Geithner also reiterated President Barack Obama’s pledge to cut spending once the U.S. economy recovers from the worst recession in half a century. "We must get our fiscal house in order or risk having government borrowing crowd out productive private investment," he said. "Treasury and the White House will work with Congress to make the tax changes that are necessary to reduce deficits and do so in a manner that is fair to all Americans." Geithner said he plans to take a tough look at the Treasury’s own budget for fiscal year 2011. For fiscal year 2010, which starts Oct. 1, the Treasury wants to add staff to work on domestic finance and tax efforts, while reducing staff in the international affairs division, Geithner said.

Former Federal Reserve Chairman Alan Greenspan signaled that the financial crisis has yet to end even as borrowing costs tumble, warning that U.S. banks must raise "large" amounts of money. "There is still a very large unfunded capital requirement in the commercial banking system in the United States and that’s got to be funded," Greenspan said in an interview yesterday in Washington. He also said that "until the price of homes flattens out we still have a very serious potential mortgage crisis." Greenspan’s comments suggest he sees a bigger capital shortfall in the banking system than reflected in regulators’ stress tests on the 19 biggest U.S. lenders. Treasury Secretary Timothy Geithner told lawmakers yesterday that banks have issued more than $56 billion in new stock or debt since the tests found 10 firms needed to raise about $75 billion.

A lack of capital at banks may inhibit lending to consumers and businesses, tempering any economic recovery. The former Fed chief, who left the central bank in 2006, said that the continued slump in home prices is putting at risk millions of borrowers. "We’re on the edge and if this thing doesn’t get resolved quickly I’m worried," he said before a meeting with House of Representatives members on financial regulation that was organized by the Washington-based Bipartisan Policy Center. Home prices will only start to stabilize once the "liquidation" rate of single-family homes has peaked, he said. "I don’t think we’re there yet." More broadly, "things have unquestionably improved" across the economy and financial markets, he said. "They’ve improved everywhere in the world. It’s remarkable."

The London interbank offered rate, or Libor, for three- month dollar loans fell 3 basis points yesterday to 0.75 percent, the British Bankers’ Association said, the 35th straight drop. The Libor-OIS spread, a gauge of banks’ reluctance to lend, narrowed to 55 basis points, the least since February 2008. It was as high as 364 basis points in October. That’s an "extraordinary improvement," said Greenspan, who last year said that the credit crisis would be at an end once the Libor-OIS spread narrowed past 25 basis points. "Virtually all of the various credit spreads not only in the U.S. but globally have come down." Alan Blinder, a former Fed vice chairman, also said on Capitol Hill that "if there are no more reversals, history will judge that by May 2009 we will have passed the worst of the crisis." "My current guess would be in terms of GDP the second quarter will be a bottom and by the third quarter we’re eking out a positive," Blinder said.

Greenspan agreed, estimating that U.S. gross domestic product will decline at an annual rate of 1 percent in the second quarter. Members of the Fed’s Open Market Committee who met in Washington April 28-29 saw "some signs pointing toward economic stabilization," and some officials detected prospects for "a trough" in the housing market’s downturn, according to minutes of the meeting released yesterday in Washington. Fed governors and district-bank presidents project that the economy will shrink 1.3 percent to 2 percent this year and grow 2 percent to 3 percent in 2010, according to median estimates released yesterday.

Greenspan separately said he opposed the creation of a "systemic risk regulator," a concept that has been backed by the Obama administration and Fed Chairman Ben S. Bernanke. The agency would be given an impossible task of trying to foresee crises, he said. "If you put the power into the hands of people, very smart people, but if you ask them to do more than is possible I think they will create problems for the system," said Greenspan, who said in congressional testimony in October that "a flaw" in his free-market ideology contributed to the "once-in-a- century" credit crisis. The former Fed chairman also reiterated his view that the central bank’s emergency lending should be done instead through the Treasury.

Citigroup Inc. and JPMorgan Chase & Co. will be required starting next year to add billions of dollars of assets and liabilities to their balance sheets under rules approved by the Financial Accounting Standards Board. The rules, effective for annual reporting periods after Nov. 15, were approved by FASB’s five-member board today during a meeting at the panel’s headquarters in Norwalk, Connecticut. The board, which writes U.S. accounting rules, is overseen by the Securities and Exchange Commission. Lenders recorded profits before the U.S. subprime mortgage market collapsed in 2007 by selling pooled loans to off-balance- sheet trusts, which repackaged the pools into mortgage-backed securities. Banks then sold those securities to other off- balance-sheet vehicles they sponsored, concealing from investors that the securities were backed by deteriorating mortgages.

"The desire to provide additional transparency to investors was the key driver behind today’s decisions," FASB spokesman Neal McGarity said in an e-mail. U.S. regulators said the 19 lenders subjected to stress tests completed this month would have to bring about $900 billion of assets onto their balance sheets because of the FASB changes, according to a Federal Reserve report released April 24. The Fed based its calculation on data provided by the banks. "This change may have a significant impact on Citigroup’s consolidated financial statements as the company may lose sales treatment for certain assets," Citigroup said in its annual report released in February. Citigroup spokesman Jon Diat declined to comment.

In March, JPMorgan estimated in its annual report that the "impact of consolidation" could be as much as $70 billion of credit card receivables, $40 billion of assets related to so- called conduits and $50 billion of other loans, including residential mortgages. Conduits are off-balance-sheet entities that purchase long-term debt and use those securities as collateral to sell short-term debt. JPMorgan spokesman Brian Marchiony declined to comment. The rule change will hurt banks and the economy by discouraging lending, said Wayne Abernathy, executive vice president at the American Bankers Association in Washington. "It will affect fee income and the economy’s ability to rebound on the lending side," he said in an interview before the vote.

The FASB vote today eliminates the so-called Qualifying Special Purpose Entity, a type of trust that was exempt from balance-sheet treatment. In July, FASB postponed by at least a year the effective date of the changes after banks and trade groups complained. The Securities Industry and Financial Markets Association and the American Securitization Forum said the measure may make companies appear to be short of capital during regulatory reviews. Investors are wary of a company’s unknown obligations as the world’s biggest banks and brokerages reported more than $1.4 trillion in writedowns and credit losses since the start of 2007, some stemming from losses in off-balance-sheet vehicles.

To keep a lid on mortgage rates, the Federal Reserve has been aggressively buying mortgage and Treasury debt. It may soon need to buy more Treasurys. The Fed is supporting debt prices to push down yields, which move in the opposite direction. Minutes of the Fed's April policy meeting showed some central bankers are willing to buy still more, beyond a promised $1.75 trillion in mortgage-related debt and $300 billion in Treasury debt. With mortgage rates low, it might be tough to see why additional purchases would be necessary. Last week, Freddie Mac said the average rate for 30-year, fixed-rate mortgages eligible for purchase by it and Fannie Mae was 4.86% -- near the record low in early April. Freddie updates these rates Thursday.

The Fed's efforts also have tightened the gap between mortgage rates and safer Treasurys. The spread between actively traded Fannie mortgage-backed securities and the 10-year Treasury yield has shrunk to less than one percentage point, roughly half December's spread. This narrowing suggests the lenders are more willing to extend credit. But rates mightn't stay low. Ten-year Treasury yields, which usually influence mortgage rates, have jumped from 2.1% in December to north of 3.25% recently. That has accounted for most of the narrowing of the spread between Treasurys and mortgage rates, which have been essentially flat, notes RBS bond strategist David Ader.

Ordinarily, higher Treasury yields push mortgage rates higher. The Fed has prevented that by buying some $79 billion in mortgage-backed securities. But eventually rising Treasury yields will put irresistible pressure on mortgage rates. The tipping point could be as near as 3.5% on the 10-year note, Mr. Ader says. In a healthy economy, rising Treasury yields and mortgage rates aren't a problem. But if yields rise mainly because the market can't absorb the glut of new Treasurys being dumped on it by a government fighting recession, the Fed might need to act. The Fed already is buying enough mortgage debt to cover some 80% of new mortgages, notes Steve Rodosky, Pimco's head of Treasury and derivatives trading. That suggests the Fed could have more impact on rates by buying more Treasurys.

Government-sponsored entity Fannie Mae in Q109 began testing the process of securitizing its whole residential mortgage loan portfolio in an effort to boost liquidity at the company. The initiative also boosted agency mortgage-backed securities (MBS) issuance in the process. A Bank of America analyst noted a surprising spike in agency MBS issuance last week. Specifically, from Wednesday to Friday, the agencies — both Freddie Mac and Fannie Mae — issued $65.5bn in MBS, bringing the total monthly agency MBS issuance to date to $162.7bn. The analyst said this spike in issuance comes as a surprise to the market, since the overall originator selling remained low over the past several weeks. However, a closer look at the data shows that about $41.5bn agency MBS issuance so far this month comes from seasoned pools; $26.9bn originated in 2003 while $4.5bn came from 2002 origination loans.

"It is likely that some banks or insurance companies that owned seasoned loans are securitizing them to sell into the current strong bid for this product, which helps them to both recognize profits and reduce the size of the balance sheet," says the analyst. And that’s just what Fannie’s been up to, according to a Securities and Exchange Commission filing dated May 8, in which the company said its unencumbered mortgage portfolio includes whole loans that Fannie could securitize for sale or use as collateral for loans under the Treasury Department’s GSE credit facility. "Currently, however, we face technological and operational limitations on our ability to securitize these whole loans, particularly in significant amounts, as our systems were not designed to support the securitization of whole loans in our portfolio into Fannie Mae MBS," company officials said in the filing. "We expect that the necessary technology and operational capabilities to support the securitization of a significant portion of our single-family whole loans will be in place during the second quarter of 2009."

The GSE’s conservator, the Federal Housing Finance Agency, warned in a May 18 Congressional report that Fannie’s liquidity situation is tight. So if the enterprise cannot issue debt and borrow through mortgage repurchase agreements, it must rely on the Treasury’s credit facility, which is scheduled for expiration at year-end ‘09. "Fannie Mae cannot securitize its $256bn single-family whole loan portfolio, although it expects to be able to securitize a substantial portion of its portfolio during the first or second quarter of 2009," FHFA’s report reads, in part. "During the first quarter of 2009, Fannie Mae conducted a successful pilot test of its ability to securitize its existing whole loan portfolio." The effort indeed appears to have been successful, as it prompted even BofA analysts to slow down and take a closer look into the issuance numbers for the month.

The Treasury Department is poised to inject more than $7 billion into GMAC LLC, the first installment of a new government aid package that could reach $14 billion, according to people familiar with the matter. As a result of the move, the government within months could end up owning both GMAC and General Motors Corp. The GM plan being devised by President Barack Obama's auto task force calls for the government to emerge with a majority stake. And the increasing infusion of taxpayer money into GMAC could turn the U.S. government into a majority shareholder there. The GMAC injection is designed to firm up the auto-financing company's battered balance sheet and allow it to continue making loans for car purchases at GM and Chrysler LLC. The Treasury already put $5 billion into GMAC in December.

The GMAC funding is an illustration of how rapidly the government effort to rescue the U.S. auto industry is escalating in cost and scope. What began as an emergency batch of loans to GM, Chrysler and GMAC in December -- totaling just over $20 billion -- now looks likely to balloon well beyond $50 billion and could approach $100 billion by the end of the year. Whether the U.S. emerges as a majority shareholder in GMAC depends on how the arrangement is structured. It's possible the U.S. might end up investing less than the $14 billion figure, the people familiar with the plan said. GMAC is now owned by GM and a group led by private-equity firm Cerberus Capital Management LP. GMAC's troubles stem from a spate of subprime-mortgage lending in recent years as the company moved beyond its traditional business of supplying fleet financing for GM dealers.

Today, bailing out the lending company goes to the heart of the administration's far-larger effort to keep GM and Chrysler alive. Analysts say both companies would fall apart without GMAC's revolving loans for their vast fleet of dealers, as well as for consumer loans to buy cars. Much of the initial money will go to help GMAC shoulder new lending responsibilities for Chrysler dealers and consumers after Chrysler's government-orchestrated Chapter 11 bankruptcy filing last month. As part of the Chrysler reorganization, the government in effect dissolved Chrysler Financial and handed its business to GMAC, creating one big auto-financing arm that would service both companies.

The auto industry is fast absorbing resources and attention the U.S. had previously directed to the banking sector. As the government pours more money into Detroit, banks are raising new capital and planning to pay back their bailout funds. Bank of America Corp. has raised about 60% of the $33.9 billion that government stress tests said it needed to offset losses it would face if the economy remained weak, including $13.5 billion in stock sales this week. Two smaller banks, Fifth Third Bancorp and Regions Financial Corp., announced stock offerings Wednesday. Treasury Secretary Timothy Geithner said large banks have taken steps to fill the $75 billion capital hole that regulators found as a result of the stress tests. He said firms have either raised or planned to raise $48 billion to fix that shortfall.

Treasury officials declined to comment on the pending announcement. GMAC spokeswoman Gina Proia said the company was anticipating government support for the Chrysler financing but declined to elaborate. A second installment of funds would be used to help the company revive its battered balance sheet. After completing stress tests of the country's top 19 financial institutions earlier this month, the Treasury and the Federal Reserve said GMAC needed to increase its capital reserves by $11.5 billion. The company, which is revamping its board of directors, is scheduled to issue a report June 8 on how it plans to bulk up its reserves. The vast majority of the money is expected to come from the federal government.

Last week, GMAC relaunched its consumer-oriented GMAC Bank under the new name Ally Bank. It also began a marketing campaign to encourage customers to turn to the bank for retail deposits, one way it's looking to rebuild its capital base. The government has already sunk nearly $16 billion into GM, and plans to put at least $12.5 billion into Chrysler. Ushering GM through a bankruptcy process, as now seems increasingly likely, could demand many tens of billions of dollars more in assistance to keep the company afloat during a reorganization and then to recapitalize it afterward. In addition, the Energy Department plans over coming years to offer loan guarantees valued at $25 billion -- and potentially as much as $50 billion, under legislation now being debated in Congress -- to retool U.S. factories to build more fuel-efficient cars. The government has also put more than $11 billion in recent months into programs to help shore up auto suppliers, car warranties, and consumer auto loans.

It remains unclear how much of this money will be returned eventually to the Treasury or other parts of the government. Many of the loans to GM and Chrysler are likely to be written off, administration officials say. Other programs, such as the government aid to auto suppliers, are essentially a revolving credit line that is meant to be replenished. At the same time, the government is converting its largess into sizable equity stakes. Current plans call for the U.S. government to emerge with an 8% stake in a post-bankruptcy Chrysler and a 55% share of a reformulated GM. The government received preferred shares in GMAC in December in exchange for its $5 billion investment in the company. With another large injection of cash, the government is expected to push for a conversion of its shareholdings into common equity. Mr. Geithner said earlier this month GMAC would need "substantial support" from the government.

Leaders in both Washington and Beijing have been fretting openly about the mutual dependence — some would say codependence — created by China’s vast holdings of United States bonds. But beyond the talk, the relationship is already changing with surprising speed. China is growing more picky about which American debt it is willing to finance, and is changing laws to make it easier for Chinese companies to invest abroad the billions of dollars they take in each year by exporting to America. For its part, the United States is becoming relatively less dependent on Chinese financing.

China has actually bought Treasury bonds at an accelerating pace over the last year — notwithstanding Chinese officials’ complaints about American profligacy. But the borrowing needs of the United States government have grown even faster. So China represents a rapidly shrinking share of overall purchases of Treasury securities. "China’s demand for Treasuries has increased over the past year, but it hasn’t increased at anything like the pace of the Treasury’s sale of new Treasury bonds," said Brad W. Setser, a specialist in Chinese financial flows at the Council on Foreign Relations. Americans and investors elsewhere are buying Treasuries instead. They are saving more and have been shifting out of other investments — including equities until the past two months — and into Treasuries.

China bought less than a sixth of the Treasuries issued in the 12 months through March. Less than two years ago, by contrast, Chinese purchases of Treasuries, which included purchases in the secondary market as well as newly issued securities, briefly exceeded the entire borrowing needs of the United States. Financial statistics released by both countries in recent days show that China paradoxically stepped up its lending to the American government over the winter even as it virtually stopped putting fresh money into dollars. This combination is possible because China has been exchanging one dollar-denominated asset for another — selling the debt of government-sponsored enterprises like Fannie Mae and Freddie Mac in a hurry to buy Treasuries.

While this has been clear for months, new data shows that China is also trading long-term Treasuries for short-term notes, highlighting Beijing’s concerns that inflation will erode the dollar’s value in the long run as America amasses record debt. So China’s rising purchases of Treasuries do not represent the confident bet on America’s future that they might seem to be on the surface. For instance, China does not appear to be dumping euros or yen to buy Treasuries, economists said. That said, recent Chinese and American data suggest that an astounding 82 percent of China’s $2 trillion in foreign reserves is in dollars, according to calculations by Standard Chartered.

The development has caught the attention of the leaders of both countries. "The long-term deficit and debt that we have accumulated is unsustainable — we can’t keep on just borrowing from China," President Obama said last Thursday. Wen Jiabao, prime minister of China, also has expressed concern. "We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried," Mr. Wen said earlier this year. China now earns more than $50 billion a year in interest from the United States, Mr. Setser at the Council on Foreign Relations calculated. China’s leaders were able to buy more Treasuries in recent months without buying more dollars because they have abruptly turned their back on the market for securities issued by government-sponsored enterprises.

China was the world’s biggest buyer of these securities a year ago, splashing out more than $10 billion a month. But in the 12 months through March, it actually had net sales of $7 billion, and ramped up purchases of Treasuries instead. China has also changed which Treasuries it buys. It has done so in ways calculated to reduce its exposure to inflation or other problems in the United States. As recently as a year ago, China actively bought long-dated bonds, seeking the extra yield they could bring compared to Treasury securities with short maturities, of which China bought virtually none. But in each month since November, China has been buying more Treasury bills, with a maturity of a year or less, than Treasuries with longer maturities. This gives China the option of cashing out its positions in a hurry, by not rolling over its investments into new Treasury bills as they come due should inflation in the United States start rising and make Treasury securities less attractive.

The big question now for policy makers and economists alike lies in whether the Chinese government’s purchases of American securities will rise or fall in the coming months. Two big forces are at work — but they are pushing Chinese investments in opposite directions and might cancel each other out. The first big shift is that Chinese foreign exchange reserves might start growing again, after shrinking early this year. A senior Chinese economic policy maker, Xu Lin, expressed concern here on Monday that the reserves might grow faster if speculators started pushing more foreign exchange into China in the months ahead. China is strongly opposed to any significant appreciation or depreciation of its currency, Mr. Xu said at a press conference. But if international investors conclude that the Chinese economy has stabilized ahead of economies elsewhere, they may start pumping more money into the Chinese economy, he said.

To keep its currency at the same level, the Chinese government buys foreign currency flowing into the country in excess of China’s needs. If overseas demand for Chinese exports recovers, then China’s trade surplus could start widening again as well. This would also tend to fatten Chinese reserves. But the countervailing trend is that the Chinese government is trying to foster channels for foreign currency to be pumped out of the country without the involvement of the central bank. The government has been buying a wider range of assets and encouraging the private sector to invest more money overseas. "That’s part of a strategic move by the authorities to diversify," said Wensheng Peng, the head of China research at Barclays Capital. "The reserves growth should accelerate because of inflows, but it will not be as large as what we observed in 2007 and the first half of 2008."

The State Administration of Foreign Exchange, which is part of the central bank, issued draft regulations on Monday that would make it considerably easier for private companies to raise dollars in China to spend on overseas investments — a step that would lessen the need for the Chinese government to buy up those dollars. This spring China has also been stepping up its purchases of commodities, which are usually bought in dollars. Iron ore has been piling up on Chinese docks, government stockpiles of crude oil and grain are being expanded and stockpiles are being started for products like gasoline, diesel and sugar. After six years of silence, China unexpectedly disclosed last month that it had been gradually buying gold from domestic producers. The country’s reserves had climbed from 600 tons in 2003 to 1,054 tons, worth $31.8 billion at prices late Wednesday.

The disclosure, which produced a frisson of excitement in gold markets, may have been aimed at reassuring a domestic audience that the Chinese government was not putting all the nation’s savings into American dollars. But the actual investment was tiny compared with China’s foreign exchange reserves — and showed that China was accumulating gold at a much slower rate than foreign currency. A person in periodic contact with China’s central bank, who insisted on anonymity to preserve his access, said that a Chinese central banker complained to him last year that "we have so much money and there’s so little gold, we can’t buy much without driving up the price."

President Barack Obama told his board of outside economic advisers that the U.S. economy is showing "some return to normalcy" and developing alternative energy sources and boosting exports are crucial to future growth. Obama addressed the 16-member group, led by former Federal Reserve Chairman Paul Volcker and drawn from the ranks of business, labor and government, as it gathered at the White House today for its first full meeting. "We expect there’ll be some stabilization of the economy," Obama said, and that "the engines will start to turn again." He offered no timetable. Created to provide outside perspective on the administration’s plans to revive the economy, the President’s Economic Advisory Board will draft recommendations after the meeting that will then be presented to Obama. The topics were energy and jobs.

Members of the panel include General Electric Co. Chairman and Chief Executive Officer Jeffrey Immelt, former Securities and Exchange Commission Chairman William Donaldson, former Fed Vice Chairman Roger Ferguson, UBS Americas Chairman and CEO Robert Wolf, and Service Employees International Union Secretary-Treasurer Anna Burger. Since March, the board’s members have been a source of economic advice for administration officials and the president, in constant contact on issues including regulatory reform, job growth and health care. Payrolls in the U.S. shrank by 539,000 in April, the least in six months, signaling the worst recession in half a century started to ease. Purchases of new homes in March were higher than anticipated even as the median sales price decreased 12 percent from a year ago. Industrial production in the U.S. fell in April at the slowest pace in six months. Still, the unemployment rate jumped to 8.9 percent last month, the highest level since 1983.

Volcker told the president and the board "it’s going to take a lot of investment over time" to reshape the U.S. economy in a post-recession era. Obama, seated next to Volcker, said there has been "impressive consensus" on the link between developing alternative sources of energy and creating jobs. "You’re seeing industry, labor and government working together more cooperatively and in a better spirit" than "in a long time," Obama said. He cited the steps he announced yesterday to toughen auto- emissions and fuel-efficiency standards as one such agreement among sometimes competing groups that will aid the economy. Obama said the move "will take a real bite out of oil imports." In the discussion about job creation, Obama told the board, "There’s no doubt that manufacturing’s not going to return to the share of the economy that it was in the 1950s, regardless of what our policies are."

Immelt told Obama that dealing with energy, emissions and climate change can help the economy. "Clean energy is the most exciting, fastest growing industry in the 21st century," he said. Immelt said GE’s 70 "energy-efficiency" products are generating about $18 billion of revenue this year, accounting for about 50,000 jobs within the company and "our supply chain" of small and medium companies. "We have to have a broad inspiration to lead in technology" in such areas as coal gasification and nuclear power, he said. "It’s out there to be had. Obama is pressing Congress to move forward on energy and climate legislation that would create a market-based cap on greenhouse-gas emissions from utilities and other human sources. Ferguson, a finance and insurance expert who now is president and chief executive of TIAA-CREF, told Obama that he’ll find there is wide support for climate legislation. Many people in the finance and insurance industries support this because "think it’s good economic policy as well as social policy," Ferguson said.

Laura Tyson, a professor at the University of California at Berkley and head of the White House Council of Economic Advisers in the Clinton administration, said afterward that climate change must remain priority for the administration. "There is the need for the U.S. to lead in this area," she said in an interview with Bloomberg Television. While Obama announced the Volcker-led board last November, legal issues establishing the group’s charter, personnel decisions and frictions with National Economic Council Director Lawrence Summers forced a delay in getting the panel running. Volcker has met with Obama at least 10 times since the president’s January inauguration and is in Washington almost every week, either meeting with Obama and administration officials or speaking to members of Congress, White House economic adviser Austan Goolsbee said.

On regulatory reform, Treasury Secretary Timothy Geithner, White House senior adviser Valerie Jarrett and Summers frequently reach out to Volcker as well as David Swensen, chief investment officer at Yale University, UBS’s Wolf, Donaldson and TIAA-CREF’s Ferguson. "They had a fairly big influence" on the administration’s decision to roll out its regulatory proposals in pieces, Goolsbee said. Administration officials emphasize that the board is advisory in nature and not meant to act as a shadow economic entity setting policy. Rather it’s modeled after the Foreign Intelligence Advisory Board, which provides an independent voice outside of regular government channels on intelligence.

Oil and gasoline prices are rising fast as Memorial Day weekend approaches, but not because supplies are tight or demand is high. U.S. crude-oil inventories are at their highest levels in almost two decades, and demand has fallen to a 10-year low, but crude oil prices have climbed more than 70 percent since mid-January to a six-month high of $62.04 on Wednesday. Meanwhile, although refiners are operating at less than 85 percent of capacity, which leaves them plenty of room to churn out more gasoline if demand rises during the summer driving season, the price of gasoline at the pump has climbed 28 cents a gallon from a month earlier to $2.33. This time, Wall Street speculators — some of them recipients of billions of dollars in taxpayers' bailout money — may be to blame.

Big Wall Street banks such as Goldman Sachs & Co., Morgan Stanley and others are able to sidestep the regulations that limit investments in commodities such as oil, and they're investing on behalf of pension funds, endowments, hedge funds and other big institutional investors, in part as a hedge against rising inflation. These investors now far outnumber big fuel consumers such as airlines and trucking companies, which try to protect themselves against price swings, and they're betting that the economy eventually will rebound, that the Obama administration's spending policies and Federal Reserve actions will trigger inflation — or both — and that oil prices will rise. "They're buying because they think it will diversify their portfolio, and they think it will diversify their portfolio against inflation, and maybe they think the economy will turn around," said Michael Masters, a hedge-fund manager who testified before Congress last year about the consequences of what are called exchange-traded funds.

Oil contracts are traded mostly in U.S. dollars, and inflation would erode the value of oil earnings, stocks or any other asset denominated in U.S. currency. Many investors are pouring money into oil futures — contracts for future deliveries of oil at specified prices — in the belief that oil prices will rise as inflation erodes the dollar's value. This turns oil futures contracts into a way for investors to hedge against inflation at the expense of American consumers, who have to pay more to fill their gas tanks as oil and gasoline prices rise. Masters and other critics say this speculative flow of money into commodities markets is a self-fulfilling prophecy that's distorting the usual process by which buyers and sellers set prices and is driving up the prices of oil, gasoline, grains and other essentials. "There is definitely an inflation premium at work here," said John Kilduff, a senior vice president of MF Global in New York, a brokerage house that helps large investors trade in energy markets.

In a report May 6, CNBC television senior energy correspondent Sharon Epperson said that traders told her that prices were disconnected from supply and demand. "Nymex traders tell me they're seeing new money coming in from passive funds that are reallocating assets away from precious metals and into energy holdings. It's this money flow — rather than the fundamental supply-demand data — that's driving oil prices higher," she reported. Morgan Stanley didn't respond to requests for comment via e-mail and telephone. "Goldman Sachs declines to comment for your story," spokesman Michael DuVally said. In a report April 16 on last year's spike in natural gas prices, the Federal Energy Regulatory Commission concluded that similar investment flows drove up the price that consumers paid to heat their homes with natural gas.

"This increase in commodity prices occurred as large pools of capital flowed into various financial instruments that essentially turn commodities like natural gas into investment vehicles," the report says. "Ultimately, we believe that financial fundamentals . . . explains natural gas prices during the year." During a visit to McClatchy's Washington Bureau, hedge-fund manager Masters also said that big institutional investors were sucking the air out of the fragile economic recovery, in part because their Wall Street partners were exempt from federal limits on how much they could bet on commodity prices. "What they don't realize is because we don't have position limits, the money they put in is driving up the price" for oil and other commodities, he said. Contracts for future deliveries of oil and other commodities are traded on the New York Mercantile Exchange, and the futures market for oil has position limits that restrict how much of the market big speculators can control.

However, big Wall Street banks are exempt from these restrictions, and there also are no such limits in derivatives markets. These vast unregulated markets involve private contracts between swaps dealers — usually big Wall Street banks — and large investors. These dark markets, also called over-the-counter markets, are thought to be 10 times larger than the futures market, and they have no position limits and no regulation. "We were in essence operating with a blindfold on for those over-the-counter markets that we couldn't see," Michael Dunn, the acting chairman of the Commodity Futures Trading Commission, acknowledged last week during a news conference to announce proposed new regulation of derivatives markets.

A stream of financial deregulation under the Clinton administration, culminating in the Commodity Futures Modernization Act of 2000, led to a global race away from regulation. "The Modernization Act specifically said we were not going to look at those; we weren't going to regulate them. Times have changed, and now we think it is time for us to look at them," Dunn said. Does Dunn think that Wall Street is partly to blame for the current $27-a-barrel run-up in oil prices or for the 12-month run-up from $70 to last July's record $147, followed by the four-month collapse in prices to $56? "Everybody has an opinion of what drove the market in the energy crisis. Do I think it was part of the problem? I do," he said. "Do I think it was all of the problem? No.

"I think monetary policies — a weak dollar — had an impact on it. I think speculation by the herd, people saying prices of fuel are going to go up and I want to get in on that" also played a part. The International Swaps and Derivatives Association, which represents the big players in these markets, said in a statement to McClatchy that fundamentals, not speculation, were driving up prices. "Oil prices are fundamentally driven by macroeconomic factors affecting supply and demand," the group said. "Energy derivatives are a key tool for helping companies manage the resulting fluctuations in prices."

Californians are well known for periodic voter revolts, but on Tuesday they did more than just lash out at Gov. Arnold Schwarzenegger and the Legislature over the state's fiscal debacle. By rejecting five budget measures, Californians also brought into stark relief the fact that they, too, share blame for the political dysfunction that has brought California to the brink of insolvency. Rightly or wrongly, voters in the special election refused either to extend new tax hikes or to cap state spending. They also declined to unlock funds that they had voted in better financial times to set aside for special purposes. Nearly a century after the Progressive-era birth of the state's ballot-measure system, it is clear that voters' fickle commands, one proposition at a time, are a top contributor to paralysis in Sacramento. And that, in turn, has helped cripple the capacity of the governor and Legislature to provide effective leadership to a state of more than 38 million people.

Clogged freeways, the decline of public schools, an outdated water system and a battered economy are just a few of the challenges demanding action by state leaders. Instead, they are consumed by yet another budget crisis, one that voters worsened Tuesday. "No one's really stepping back and confronting the harsh realities that face our state in a critical sense, because of constraints put on our elected leaders," said Mark Baldassare, president of the Public Policy Institute of California. "We're unable to focus on the long term and the big picture at a time when we desperately need to do so." The results Tuesday fit Californians' long-standing pattern of demanding what is ultimately irreconcilable, all the more so in an economic downturn: lower taxes and higher spending.

"We all want a free lunch, but unfortunately that doesn't exist," said former Gov. Gray Davis, whose 2003 recall stemmed largely from a budget crisis brought on by the dot-com bust. For decades, Davis said, Californians have been "papering over this fundamental reality that the state has been living beyond its means." Davis and many other elected officials bear some responsibility for that. But so do voters. In the Proposition 13 tax rebellion of 1978, Californians voted to require a two-thirds approval by the Legislature to raise taxes, a major obstacle to budget agreements. Over the last couple of decades, voters have also passed a patchwork of ballot measures directing billions of dollars to favorite causes, among them public schools and transportation projects.

On Tuesday, Californians showed they were unwilling to scale back their demands in tight times: Voters turned down propositions that would have freed up money that they set aside years ago for mental-health and children's programs. "The irony is that the more the hands of the Legislature and governor are tied up, the more frustrated people are," said Tim Hodson, director of the Center for California Studies at Cal State Sacramento. Together, voters' piecemeal decisions since the 1970s have effectively "emasculated the Legislature," said John Allswang, a retired Cal State L.A. history professor. "They're looking for cheap answers -- throw the guys out of power and put somebody else in, or just blame the politicians and pretend you don't have to raise taxes when you need money," he said.

"This is what the public wants, and they deceive themselves constantly. They're not realistic." The public's contradictory impulses were laid bare by a recent Field Poll. It found that voters oppose cutbacks in 10 of 12 major categories of state spending, including the biggest, education and healthcare. Yet most voters were unwilling to have their own taxes increased, and they overwhelmingly favored keeping the two-thirds requirement for tax hikes. "They clearly want more in services than they're willing to pay for in taxes," said Ethan Rarick, director of the Robert T. Matsui Center for Politics and Public Service at UC Berkeley. Also intensifying California's troubles is a surge in debt, often with voter consent at the ballot box, which makes future budgets harder and harder to balance. Under Davis, outstanding general-obligation debt jumped from $26 billion to $37 billion; it has soared to more than $70 billion under Schwarzenegger, according to the state treasurer's office.

Adding to the state's difficulties is the complexity of many ballot measures, no doubt a factor in the defeat of the main budget measures that lawmakers put before voters Tuesday. "We pay the legislators to go to Sacramento and figure these things out," said Denise Spooner, a lecturer on California history at Cal State Fullerton. As for the cumulative problems created by the last few decades of ballot-measure voting, she said, "I certainly don't think this is what the Progressives had in mind." To John Hein, a veteran Sacramento campaign consultant, the absence of any master vision by voters appears to be a key flaw in the state's recent history with ballot measures. "They kind of take each issue in a microcosm, rather than relate the decision to prior decisions, or future decisions that they might make," he said. "Voters don't think about the consequences of how one thing fits with another."

Others point to the term limits that voters imposed on state officials in 1990 as an enduring problem. Lawmakers who focus on quick career advancement tend to neglect California's long-term problems, they say. Whatever the ups and downs of the proposition system, California's voters have seen themselves for a full century as "the arbiters of the future of the state," said social historian D.J. Waldie. To Waldie, the grim circumstances of Tuesday's election suggest that they are losing faith in any grand ambitions for public investment in California's future. "I'm rather pessimistic at this point," he said. "We're reaching the point where Californians are throwing in the towel."

California’s ballot results highlight a simple fact: Californians like electing big-spending state representatives but hate paying the bills when they come due. This natural voter preference is universal, but is exacerbated by a wealthy polity of 37m inhabitants that is not fully self-governing, but subject to a distant central authority in Washington. Its discontents cannot be removed through restricting the right of referendum, which would further alienate voters from their government. More radical surgery is needed: splitting the state into more accountable government units. The principal advantage of a federalist system is its ability to devolve local tax, spending and regulatory functions to government units small enough to respond to the wishes of local electorates who pay the bills.

Policies thereby vary considerably across the federation, being tailored to the wishes of relatively modest electorates who share substantial lifestyle and economic interests. National governments are restrained from excess by their responsibility for maintaining plausible fiscal and monetary policies in a world where bailouts do not exist (the US and even California being too large for an IMF bailout.) America’s Founding Fathers understood this. The US government never defaulted on its debt, in spite of several wars and the abolition (twice, in 1816 and 1836) of the central bank. State governments were initially less careful; of the 28 states existing in the depression of the 1840s, five (Michigan, Mississippi, Arkansas, Louisiana and Florida) repudiated their debts completely while four more (Maryland, Pennsylvania, Indiana and Illinois) stopped paying interest for several years. A second wave of defaults came in the 1880s, when eight Southern states repudiated debts that had been assumed under the post-Civil War Reconstruction.

California in 1850 had a population of only 93,000, so its state government was fully accountable to its people, even though its vast size made communications difficult. Today California’s population at 37m is 50% larger than that of Texas, the second most populous state. Each of its 80 state legislators represents around 460,000 people and its electoral districts are gerrymandered along party lines. Ethnically, economically and in terms of lifestyle California is more diverse than most countries (the largest EU country, Germany, has twice the population of California but 20% less land mass). State-wide public sector personnel structures and pay scales that are appropriate for high-cost coastal areas produce overpaid and under-employed state employees in rural areas, imposing regulations that may be poorly matched with those areas’ more traditional lifestyles and wishes.

These higher costs result in conservative rural areas appearing to be subsidised by the liberal coasts (in terms of receiving more from the state budget than they pay) but in reality their excess "receipts" consist of salaries they should not need to pay and unnecessary services. California’s budgetary spending tends to grow more rapidly than its economy because it is to some extent a "free lunch"-- the increasing share of federal grants in state revenues allows the state government the luxury of using political pressure in Washington to cover budget gaps.

In 2007, California had only the sixth largest per capita tax burden of the 50 US states, the twelfth largest per capita spending burden and the 23rd largest per capita debt. It was also the seventh richest state per capita. Thus its budget problems should be economically manageable if its political systems functioned well. However the referendum process, introduced by the Progressive governor Hiram Johnson in 1911, allows the electorate to repudiate tax increases imposed by the state government to balance the state budget (which is itself a constitutional requirement). This happened in 1978, when Proposition 13 capped a rapidly rising property tax, and it happened again on May 19.

Removing the referendum possibility without reforming state government would help solve California’s current budget problem. However it would dangerously reduce the state government’s legitimacy and accountability, alienating voters further. More representative government might be achieved by quintupling the number of state representatives from 80 to 400, thus reducing each representative’s constituents from 460,000 to 92,000. However that would be very expensive, and would not solve the problem of coastal urban communities imposing costs and regulations on rural areas.

A more radical alternative would be to break up California into new states whose populations were more typical of other US states; splitting California into four could create states similar in size to Michigan, Georgia and North Carolina, for example. According to Article 4 Section 3 of the US constitution, such a split can be carried out with from the state legislature (which by the California constitution would require a two thirds majority) and Congress – in practice, a state constitutional convention would presumably be an appropriate mechanism.

A possible split of California into four states, each of which would be regionally coherent might be:

San Diego/ Orange County /Inland Empire: 5 counties, population 10.4m in 2008, about 45% of Hispanic origin. Strong military presence; socially conservative and economically moderate. Politics maybe similar to New Mexico.

Such a split would create four states with coherent boundaries, populations and economic bases. It would remove the bizarre current anomaly whereby the liberal big-spending coastal communities both subsidize the more conservative farm areas and impose unnecessary costs on them. The rural state could achieve substantial cost savings from lower salary scales for teachers and other state and local employees and a less complex bureaucracy and regulatory system.

Politically, three of the four states should quickly arrive at a satisfactory political and budgetary balance, with the amount and mix of state services provided differing substantially between them, but all remaining within the current US range of policy mixes. The fourth new state, Los Angeles, would probably arrive at a political/economic policy balance well outside the current US norm. However its residents would retain the entire responsibility for finding a workable match between state sector growth and private sector viability without subjecting the entire state to their experiments. In terms of national politics, a split should have little effect.

As four states, California would have six extra Congressional seats, but Democrat gains from this would be balanced by the decennial redistricting process being less subject to manipulation in smaller states. The four states would have eight Senators instead of two, but the split would generally be around 5-3 Democrat, leaving the current balance unchanged. California has become too diverse, culturally and economically, to work well within the constraints of its 1850 status and its modern democracy-on-steroids. Breaking it up on an amicable basis could create three highly successful and well managed medium-sized states of different types and one laboratory for the left.

It was, the president declared, "an extraordinary gathering". Bounding into the White House rose garden for his latest policy pronouncement, Barack Obama this week unveiled his plan to limit US petrol consumption and reinvigorate the domestic motor industry. Compared with what had preceded it, it was extraordinary, for not only did he unveil a rise in fuel efficiency standards after years of drift, but his administration had also hammered out a consensus among government agencies, states led by California, and auto companies. In the sweep of history, however, it was very ordinary indeed. Yet again, a president was placing his faith in government regulation to limit his countrymen’s fondness for big, gas-guzzling vehicles.

Instead of the simplest, most obvious and least expensive way of achieving that end – raising the national excise tax on petrol – the president was again relying on a complex, dirigiste intervention. The initiative has its good aspects. It provides one set of rules, covering efficiency and emissions standards, that car companies have to comply with, rather than a patchwork. In the old days, General Motors and Chrysler would still have fought back; they are in the president’s pocket now. It is also the politics of the possible. Although a tax of $1 or $2 per gallon of petrol would be more effective in altering consumer behaviour and giving a clear demand signal to manufacturers to produce more fuel-efficient vehicles, it would not get through Congress.

But it is an inefficient – and probably ineffective – way of meeting the twin aims Mr Obama has set out for the motor industry and the US carmakers: to curb fuel consumption and dependence on foreign oil and to help the Detroit three "once more outcompete the world". The corporate average fuel economy (CAFE) rules that Mr Obama wants to tighten have a history of causing unintended consequences. They were passed in 1975, following the oil crisis, to get drivers to buy smaller and more efficient cars, but instead gave Detroit an incentive to make sports utility vehicles. The basic problem with the CAFE standards is that, rather than altering patterns of demand, they attempt to ration supply. This flaw is exacerbated by the divide in the rules between standards for "cars" and for "light trucks", which Detroit has ingeniously exploited.

By the 1980s, petrol was cheap again and drivers did not want to buy the lighter, less powerful cars that were fuel-efficient. Instead, they switched en masse to people carriers and SUVs that were classified as light trucks, and so could be thirstier. "The rules ruined the big cars of the 1970s but are largely responsible for the light truck," says George Magliano, an analyst with IHS Global Insight. Trucks including SUVs, people carriers and car/SUV crossovers made up 20 per cent of light vehicle sales in 1973, but peaked at 54 per cent in 2004. The proposed new rules – raising the average fuel consumption of new vehicles to 35.5 miles per gallon by 2016 compared with 25 mpg this year – are more testing. They also close some loopholes, imposing a limit for each class of vehicle as well as the fleet, and making it harder for some passenger trucks to escape.

But they have the same design flaw of allowing trucks off lightly. They will also have the perverse effect of encouraging driving by making it cheaper, one reason Americans drive 1.7 times as many miles as in 1973 although the population is only 47 per cent bigger. The conventional wisdom is that Americans like big vehicles and not much can be done about it, but the evidence is that they behave much like other consumers. When the oil price rose sharply last year, sales of light trucks collapsed and demand for hybrid petrol/electric cars rose. As it fell again, the old patterns returned.

Crucially for Mr Obama’s aspirations, this has also weakened the domestic manufacturers. The fact that the US market has been so distorted – and that the Detroit three have tilted towards high-margin light trucks, leaving Asian rivals such as Toyota the slimmer (in profit terms) pickings of cars – has sapped their ability to compete globally. Toyota, having unwisely been lured into a face-off with Detroit in big pick-up trucks, now faces competition for leadership in fuel-efficient engine technology. But it comes from Honda, another Japanese company with an environmentally conscious domestic market, while the Detroit companies remain laggards. If anything, Detroit’s prospects have been further impaired by the financial crisis. While Ford retains a global presence, GM is shedding Saab and Opel and reducing its ability to bring European cars to the US.

The peculiar nature of the US market means there is little prospect of Detroit’s following Toyota’s and Nissan’s success in exporting vehicles designed for their domestic market to other parts of the world. These rules are unlikely to alter that. A petrol tax is a rare example of a policy that would be simple, let the market operate, and be likely to achieve Mr Obama’s aims. "This is a noble long-term goal, but a gas tax is an immediate incentive to change," says David Gerard, an economist at Carnegie Mellon university. Unfortunately, raising the federal petrol tax, which is currently 18 cents per gallon, to levels that would make it bite is not politically achievable in the US. Instead, the president has had to rally everyone around a clunky and leaky regulatory alternative. That really is extraordinary.

Eurozone prospects brightened this month with the pace of economic contraction slowing markedly, according to a closely-watched survey that will boost hopes of the region’s recession ending this year. Purchasing managers’ indices for the 16-country region jumped more than expected in May to the highest for eight months. Although they still indicated economic activity was contracting, the rate of decline fell for the third consecutive month. The improvement in Germany, the eurozone’s largest economy, was particularly sharp. The latest data will come as a relief to European policymakers after last week’s news that eurozone gross domestic product contracted by 2.5 per cent in the quarter compared with the previous three months – significantly faster than in the US or UK. The indices "provide further evidence of a sharp recovery," said Chris Williamson, chief economist at Markit, which compiles the purchasing managers’ indices. The latest readings were consistent with second quarter GDP falling by about 0.5 per cent, he said.

Organisations such as the International Monetary Fund, the European Commission and European Central Bank have forecast a eurozone recovery only in 2010. But Lucas Papademos, ECB vice president, argued more recently that it "may start sooner than previously envisaged". The eurozone economies, especially the export-led German economy, proved particularly vulnerable to the collapse in global demand after the failure of Lehman Brothers investment bank. Hopes of a recovery are based on signs that companies have run down inventories and will need to step-up production to meet orders. At the same time, the stabilisation of the banking sector has helped boost confidence, while Germany appears to be benefiting from a modest revival in foreign demand for its exports. However, eurozone economic prospects are likely to remain blighted as the impact of the sharp contraction in activity feed through into the labour market. Markit said that the pace of job losses had eased this month but only slightly compared with the record pace reported in April.

"The eurozone is still reeling from the massive collapse in production over the past year, and with unemployment likely steadily over the course of this year, the eurozone looks set to be mired in recession for some time to come," said Colin Ellis, European economist at Daiwa Securities SMBC. The purchasing managers’ indices have shown eurozone private sector economic output contracting for 12 consecutive months. May’s "composite" index, covering manufacturing and services, stood at 43.9 in May, up from 41.1 in April, the highest since September. Germany’s index leapt from 40.1 to 44.4. A figure below 50 indicates a fall in activity. Markit reported that forward-looking parts of the survey pointed to further improvements in coming months. Expectations about future levels of activity in the service sector were the most optimistic in 13 months. In manufacturing, the ratio of new orders to stocks – which offers a guide to future trends in output – was the highest for 15 months.

There are worse ways to spend time as a hostage than being locked in the headquarters of one of France’s best-known champagne houses. Back in the summer of 1993, the boss of Moët & Chandon was trapped in his Epernay offices overnight with only a fridge full of bubbly for company. Meanwhile, workers barricaded themselves in the cellars and cracked open a few of the 95m bottles laid down in the dusty warren of tunnels to protest against the group’s plan to commemorate its 250th anniversary with 250 job cuts. Bossnapping is nothing new in France, almost as much a part of the culture as baguettes and brie. But in recent months, the economic crisis and rising tide of factory closures and restructurings have prompted an unusually high rate of corporate hold-ups. At least 10 companies over the past two months have had managers held hostage, while many more have had factories occupied.

Though most have been peaceful, and no hostage has come to serious harm, few experiences have been as amiable as that champagne-fuelled evening at Epernay. Two managers at the French factory of Molex, the US connectors group, were jostled and bruised as they walked away from their 26-hour ordeal last month (and another Molex manager received death threats in the post). Only last week, 74 energy workers were arrested after extensive damage was done to the Paris offices of power services groups ErDF and GrDF during a protest over pay. The growing radicalisation of protest is worrying the French government, which has privately discouraged managers from pressing charges against kidnappers and protesters to avoid inflaming an already tense social situation.

But companies, too, are struggling with the potentially explosive issue of how to implement restructuring plans in the heat of the economic crisis. The anxiety is particularly acute among foreign companies, unfamiliar with the French tendency to take direct action and where bossnappings have been most frequent. Restructuring specialists report a surge of interest in advice from foreign clients, and small businesses are sprouting up across the country offering guidance on how to deal with a hostage situation. Xavier Lacoste, chief executive of social relations firm Altédia, says the first lesson of bossnappings is not how to survive them but how to avoid them. This involves deep dialogue with staff, he says. "You do not have this kind of movement in companies with a tradition of discussion."

He cites Peugeot and Renault, the French carmakers, which have been able to implement sweeping job cut plans without managers being taken hostage, although they have had their fair share of strikes. Through negotiation, the companies have arrived at innovative solutions, such as white-collar workers volunteering for temporary wage cuts to help reduce job losses in the factories. "People will accept job cuts as long as you treat them with dignity," he adds. Companies also have to be consistent in their treatment of redundancies, says Mr Lacoste. He cites the kidnapping of four managers at Sony, when the Japanese electronics group announced the closure of a French factory not long after a previous hefty redundancy plan. "Not only were they closing the factory but the workers who were losing their jobs were getting less than those who left before."

Many experts note that the hostage-taking often seems driven by a sense of despair over decisions taken in remote head of?fices with little sensitivity shown for the local situation. "In certain regions, when a factory closes it is the last one remaining. And the workers have no possibility of finding another job," says Mr Lacoste. Jacques Buhart, a partner at law firm Herbert Smith, has advised dozens of international companies on restructurings and says the remoteness of decision-making can be a big problem in implementing job cut programmes. "People don’t understand that the power to decide the fate of these factories is not in France," he said. "The first thing I tell clients is that they are going to be kidnapped," he says, jokingly. "The second is that they have to be prepared to go to court."

But not to press charges. Instead, the court appearance is part of the ritual required to implement a restructuring plan. Under French law, the works council must be informed of any job cut proposals, and give an opinion on them, before they can go ahead. The opinion is non-binding, so even if the works council rejects the plan, it can still be enacted. But, says Mr Buhart, "the position the unions take is to say they do not have enough information to give an opinion. So the company gives more and they still do not have enough. At some point management has to go to court to say they have given all the information necessary for an opinion". Then, he says, a judge will normally demand a few details but is also likely to rule that the works council will then have to opine. The real problem is that "all this can take six months".

Long before getting to that stage, Mr Buhart says managers have to prepare the way politically. In France, where pride in the country’s industrial heritage runs deep, closing a factory – no matter how unprofitable – can be a minefield. Once the plan is drawn up, managers have to get the government’s local representative – the Paris-appointed prefect – onside. Foreign companies are often reluctant to do so, he says, for fear of government hostility to job cuts. But failure to do so could cause even greater political outrage if employee protest gets out of hand and the auth?orities had not been forewarned. "It is absolutely essential" to talk to the prefect, Mr Buhart says. "You have to go with the timetable and explain exactly what you are doing."

The real risk of political controversy lies with local officials, according to other restructuring specialists. "The one you don’t tell is the local mayor, because he will have to be re-elected," says one who asked not to be named. Yet companies need not fear a bout of conflicts if they recognise that workers have not aimed to stop restructuring itself, suggests Guy Groux, social relations professor at Sciences-Po. "The claims are about the value of the payoffs and the conditions of departure. They are not defending jobs." Mr Lacoste agrees. In the end it often boils down to a question of money. "Companies need to be aware that the differences unions are asking for is often not a lot."

Alistair Darling must stand ready to pump more capital into Britain's beleaguered banks, perhaps nationalising other high street names, the International Monetary Fund has warned. The Fund believes that although the drastic measures to prop up Royal Bank of Scotland, Lloyds Banking Group and other major lenders had prevented them from collapse, more public money needs to be poured in if the economy is to get back to full strength. The alternative is a "zombie" recovery as banks continue to withhold lending for years, the IMF has told the Treasury. The warning formed part of a stark assessment of the UK economy. In a double-pronged assault on the Budget, the Fund praised some of the rescue plans but dismissed the Chancellor's claim that the recession will be over by Christmas. It said he must start paying back debt significantly earlier than he projected last month.

However, it is the IMF's assessment of the financial system which will cause more jitters, since many have assumed that enough public money has now been put into the banking sector. The Fund's concluding statement, following a week-long visit to the UK, said; "The financial system may not yet be repaired to a level where banks are ready to increase lending sufficiently to underpin a strong recovery. Although banks are expected to continue to remain above minimum regulatory capital requirements, further shocks will lead to an erosion of capital buffers." It added that the Government must encourage banks to raise more capital, and to "stand ready to provide further public support where needed." Although it is not explicitly stated in the report, the Fund believes further injections of public money may prove inevitable if the Government wants to increase lending from its current low levels, and help bring an end to the credit crunch.

In comments which will spark fears among bank investors, the Fund also suggested banks should preserve their capital by "restraining dividends if required and converting preference shares to common shares." The assessment follows a similar warning from Bank of England Governor Mervyn King last week. The Fund maintained that the economy will shrink by 4.1pc this year - the biggest peacetime contraction since the 1930s, and by a further 0.4pc next year. More damaging is its criticism of the Budget's borrowing forecasts. It said: "The success of the current policy package hinges on the continued trust in the sustainability of the fiscal position", adding that the Government must "put public debt on a firmly downward path faster than envisaged in the 2009 Budget." The Fund favours sharper spending cuts and bringing the Budget back in balance over an electoral term.

The amount of money lent to home buyers and those remortgaging fell by 60pc in April compared with the same month last year, new figures show. Gross mortgage lending declined to an estimated £10.4bn in April, a fall of 9pc from £11.4bn in March and of 60pc from £26.1bn in April 2008, according to the Council of Mortgage Lenders (CML). Some of the fall could be attributed to the fact that Easter fell in April this year, the CML said, while Easter last year was in March. Taken together, lending for March and April was down by 57pc on a year earlier. Michael Coogan, the CML's director general, said: "It's still too early to spot a clear pattern of recovery in the housing market, as some commentators have suggested. "Activity remains weak, and we have said we will see volatility in monthly lending figures as we bounce along at the bottom of the market.

Our forecast for gross lending of £145bn in 2009 remains unchanged." David Hollingworth of London & Country Mortgages said: "It’s clearly disappointing to see the lending figures drop versus last month and they act as a stark reminder that the market remains tough, with a continued restriction in mortgage availability. "However, on a brighter note there are definite signs of growing buyer interest and the hope will be that this will translate through into increased purchase activity." Recent signs of returning health in the property market include the launch of a 95pc mortgage by Lloyds TSB, which is expected to encourage first-time buyers, and moves by Abbey, the Spanish-owned bank, to relax its mortgage lending rules. It also emerged recently that estate agents sold more houses in April than in any month since October 2007.

A quarter of China's 4 trillion yuan ($586 billion) economic stimulus package is going to rebuilding from last year's devastating earthquake in Sichuan, the government said Thursday in an outline of how the program is being carried out. The report by the National Development & Reform Commission, China's main planning agency, was the first detailed outline of how China intends to spend the stimulus funds and what it has done so far. Questions remain, however, over how much of the money is newly allocated and how much predates the package's launch in late November. Spending related to rebuilding from the May 12, 2008, earthquake in central China totals 1 trillion yuan ($14.6 billion), the report said. The 7.9 magnitude quake, which left nearly 90,000 people dead or missing and another 5 million homeless, caused such devastation across the area centered in Sichuan province that it is unclear if the region will ever fully recover. But the authorities have sought to showcase the reconstruction effort. The NDRC report showed another 1.5 trillion yuan ($22 billion), or 37.5 percent of the package, going to other construction of roads, railways, airports, irrigation and other basic infrastructure across the country.

Such programs are meant to help stimulate demand, improve China's overall productivity and to help provide jobs for the tens of millions of workers who were laid off from industries hammered by a downturn in demand due to the global economic crisis. But the report gave no details on exactly how much money has been spent so far or how many jobs may have been created by the accelerated public works programs. Among the details it did give:--By the end of April, construction of 214,000 units of new or improved housing was completed, with construction started on another 650,000 units -- part of a 400 billion yuan ($58.6 billion) housing construction program.--As part of a 370 billion yuan ($54.2 billion) program for improvements in rural villages, 14.6 million people got access to safe drinking water and 20,000 kilometers (12,500 miles) of new roads were completed.--Some 6,500 basic public health services projects were completed, part of a 150 billion yuan ($22 billion) program to improve public health and education.The central government is providing 29.5 percent of the funding for the overall stimulus program, the agency said, with the remainder coming from local governments and other sources. Other spending categories include 370 billion yuan ($54.2 billion) in funding for innovation and upgrading industries and 210 billion yuan ($30.7 billion) for improvements in energy efficiency and pollution abatement.

This year, Nouriel Roubini, the economist known to the general public as Dr. Doom, Prophet of the Financial Apocalypse, spent the early hours of Mardi Gras on the floor of the Frankfurt Stock Exchange. It was only 11 a.m., but the party was rollicking. Traders careened around the floor, hooting and honking, dressed as dragons and devils and convicts. Rock music roared overhead, and no one seemed to care that, by the bye, the market had tanked. Tickled, Roubini registered the flicker of amusement on his Twitter thread: "Nouriel is at the Frankfurt Stock Exchange," he wrote, "where everyone is dressed in Mardi Gras costumes even if the market is down 2.5%."

Roubini has always been a bon vivant--a trait that has mesmerized the tabloids ever since Facebook photos surfaced of him, the professional pessimist, partying ... with women. But, today, there was no time to celebrate. First, he had to go see Axel Weber, head of the nearby German Central Bank, to discuss "how the German taxpayer is going to have to bail out the lazy Italians and the lazy Greeks," who were up to their eyebrows in debt. Then there was a panel discussion with finance gurus Robert Merton and Stephen Ross; there were clients to counsel, a keynote address to deliver, and e-mails, hundreds of e-mails, slowly piling up in the BlackBerry on his belt. By the time he responded to the ones worth responding to and updated his blog, it was nearing 4 a.m., and he only had time to sneak in a few hours of sleep before another day of flights, meetings, conferences, and TV appearances.

When I caught up with Roubini three days later, he was draped over a booth in an Upper East Side diner, his hair rumpled, collar undone. The speckled blue tie he had worn on Maria Bartiromo's show that afternoon was gone. His speech was still a rapid spit-out of facts and favored metaphors (the government "cannot be half-pregnant" with the banks), with modifiers in just the wrong places ("I was all day long giving talks"), but it was disembodied: Roubini was wiped and having a hard time propping himself up. Now that his early prophesies of a "bloodbath" have come to pass, Roubini's star is at its apex, and everyone wants a little ray of its gloomy light. This includes his editors at Forbes, The Wall Street Journal, and a growing number of other publications; his students at NYU, where he is a popular tenured professor; and his consultancy's swelling portfolio of clients--the World Bank, IMF, 50 central banks, and 30-odd finance ministries among them. He also appears on CNBC almost every day.

He is a curious presence on the network--the antipode to its yawping, fratty ethos--and he is trotted out to play the foil, delivering bad news with a dark and steady gaze, punctuated by the occasional impish smile. It's good for business, Roubini admits, but he makes no secret of his contempt for the network's roster of "perma-bulls who declare that this is the dramatic and cathartic event that signals the bottom of the crisis, and recovery is three months ahead." "What a delusion," Roubini sniffs. Though he hasn't attacked the Obama administration's policies with Paul Krugman's fury, and though he is no longer the most bearish of the bears, his short-term outlook is still quite bleak: a 36-month downturn, double-digit unemployment, and sluggish, recessionary growth well into 2010. At best.

Roubini is widely seen as an incorrigible pessimist, and, in the years leading up to the crisis, this nose for doom pitted him against his more cautious colleagues in the academy and the regulatory agencies, as well as the ebullient in-house economists at banks and hedge funds. Even those who predicted a downturn didn't recognize the extent of the problem. They homed in only on certain pet indicators--trade imbalances, say--and saw a temporary, contained recession in the works. Roubini, on the other hand, saw something else entirely. Like a good mechanic or internist, he understood the wiring. He knew, for instance, that current-account deficits were integral to the housing bubble, and that those two factors linked up to countless other factors at home and abroad.

So he took what, back in 2004, was just a hunch--there is a foreign-financed bubble in the United States--and eventually pushed it, step by logical step, into a Socratic cul de sac: We are headed for an unmitigated financial disaster that will completely change the way the world does business and leave no one untouched. The theory seemed far-fetched, even hysterical--until it came true. By calling the recession, Roubini has traveled from the Jeremiah wilderness to become one of the world's central economic authorities. So, does he have a unique ability to penetrate data, or was he simply a relentless pessimist the business cycle was eventually bound to vindicate? Is he our great economic seer, or did he just get lucky?

Roubini can be a pleasantly phlegmatic man, but, whatever the topic, he almost always positions himself as a clear-eyed outsider battling against the half-wits. "Silly" is one of his favorite adjectives, as is "ridiculous." When we met in New York, he wasted little time in dismantling the myth of his newfound stardom. "People sometimes write these articles saying, 'He was an obscure academic professor and now he's become a rock star,'" he said, one arm absently bumping an increasingly irritated man enjoying a club sandwich behind him. Then there is the problem of Roubini's pop-culture image: Dr. Doom, the partying pessimist. He hates both parts of the packaging. "In many ways the Dr. Doom moniker is inappropriate," he punched into his BlackBerry, unprompted, one very early morning in New Delhi. "I turned out to be much more of a realist than a pessimist, grounded in reality rather than living in a bubble of delusions about how bad things would get." And he flares at any mention of his reputation as a playboy, accusing Nick Denton, the publisher of Gawker Media and the main peddler of these allegations, of anti-Semitism (Denton's mom is Jewish).

If Roubini slides easily into the role of victim, it's a stance that his ancestral history may have predisposed him to. The Roubinis are from Mashad, a city on the eastern fringe of Iran and the resting place of the Imam Reza, the eighth of the twelve Shia imams. This made Mashad a major religious hub and, thus, a difficult place for its Jewish community, the Roubinis included, to live. The city's Muslims and Jews, however, managed to maintain a tense equilibrium for centuries until, in 1839, a Jewish woman got a strange prescription for an abscess on her hand: cut open a puppy, stick your hand in its innards, hold for an hour. She carefully followed the Muslim doctor's advice, but got the timing wrong, killing the dog on a major Muslim feast day. This was interpreted as a mockery of the holiday, and the town exploded in violence. When it was over, 36 Mashadi Jews were dead and the rest were forced to convert to Islam, an event that came to be called the Allahdad. For the next century, until the Iranian state slowly loosened its grip in the 1940s, the Jews had to secretly keep their faith while maintaining an elaborately Islamic facade. The trauma of the Allahdad forged a strong insularity among the Mashadi Jews, one they maintain even in the exile of Long Island and Israel--and it gave them the sense that the unimaginably bad is nearly always possible. "It's like a big tribe," Roubini says. "They mate among each other; they don't even mix with other Jews."

Roubini himself was born in 1958, not in Mashad, but in Istanbul, where his parents had a short layover before moving on to Tehran, Tel Aviv, and, finally, Milan, where the family set up its Oriental rug business and lives to this day. Because they arrived in Italy when they were young, Nouriel and his two brothers, born one after the other in the span of 21 months, were able to duck right into Italian society (though they spoke Farsi at home) and, in the typical way of first-generation immigrant children, disappear. The Roubini boys came to immerse themselves in politics during the 1970s, when Italy was rocked by social unrest and domestic terrorism; according to his youngest brother David, Nouriel began leading student assemblies on the events of the day. "I was like everybody else, the son of a good upper-middle-class family, and like many of my generation, I was socially conscious," Roubini says. "I wanted to make the world a better world. And, probably, my interest in economics came from my interest in politics."

The interest was largely incomprehensible to Roubini's parents. In the Mashadi community, a boy was expected to go into his father's line of work; many didn't finish high school. "Unlike Ashkenazi Jews, Middle Eastern Jews put less emphasis on education," Nouriel explains. "They were more about business. There was no particular impetus to learn. So I'm a little bit like an outsider because I broke out of it." He has remained an outsider ever after, never fully inhabiting any role or place since his grad-school days at Harvard, when he was able to pursue a blend of academic economics with tangible questions of policy. After seven years of teaching at Yale, he was drawn south, to New York, to fill the cultural void that New Haven had opened in his life. (He missed the opera in particular. At one Yale party, an advisee's wife walked in on Roubini and four other economists ripping through the Catalogue Aria from Don Giovanni, a list of the paramour's conquests: "In Italy, six hundred and forty;/In Germany, two hundred and thirty-one;/A hundred in France; in Turkey, ninety-one;/But in Spain already one thousand and three.")

But, at NYU in the mid-'90s, he wasn't fully comfortable, either, and was drawn south again--this time to the policy battles of Washington, where he served briefly at the World Bank and the IMF, before deciding to abandon academia for a while and adopt the life of a bureaucrat at the White House and Treasury (where he was Timothy Geithner's adviser). That, too, did not satisfy him for long. Two years later, he was back in New York, trying again to fuse economic policy with theory, and, in 2005, he added another element to the mix: RGE Monitor, a multimillion-dollar international consultancy. The crisis has blessed Roubini with fame, wealth (mid-recession, RGE is still growing), and odes from his peers. Nassim Taleb, who also predicted a catastrophe in his book The Black Swan, calls Roubini "the best living economist"; heavyweights like Brad Setser, Simon Johnson, and Kenneth Rogoff were nearly as flattering in their appraisals. And yet, Roubini still sees himself as outnumbered and put-upon, the man no one will listen to until it is too late.

He also bristles at anything that smells remotely of constriction. When two people from the notoriously on-message Obama campaign approached Roubini and asked him to come onboard last year, he declined. Though Roubini had been happy doing policy in the late '90s, he had chafed at working longer days for half the money, and his recommendations were being shorn of their Roubini-esque fullness. "When I was in government, every word I said in public, I had to clear it with general counsel," Roubini says. "I prefer to be a free thinker and be able to write daily without having to worry about that." Before they left for Washington late last year, he told his old colleagues Geithner and Larry Summers that, though they were free to contact him, he was happy directing policy indirectly, on television or on his blog. "I cannot do everything," he says. "You have to choose."

Some economists--strict academics mostly--have long considered Roubini a quack. They sneer at his approach, which is wide, deep, and deeply unconventional. When he travels, for instance, he says his research includes talking to "everyone from the airport cab driver all the way to the finance minister." One prominent economist who studies recession indicators recently slammed Roubini for his "subjective," "wild man" predictions because they don't always rely on econometric modeling. And Roubini certainly didn't help his case at an IMF conference in September 2006, when he guesstimated the chances of a world recession at 70 percent before offering, by way of explanation, that he had pulled the number "just out of my nose." Anirvan Banerji, an economist with the Economic Cycle Research Institute, has been particularly dismissive of Roubini's forecasting abilities: "The average time between recessions is about five years in the postwar period," he says. "So, if you forecast a recession one year and it doesn't happen, and you repeat your forecast year after year ... at some point the recession will arrive."

And Roubini has undeniably overshot. In 2004, he predicted that the oncoming recession would precipitate the crash of the dollar. The crisis has mainly buoyed it. On September 1, 2005, three days after Hurricane Katrina made landfall, Roubini told Reuters that economic disaster was imminent. What followed instead was a bump in financial activity that forestalled the recession for more than two years. All the while, though, Roubini understood better than anyone just how weak the fundamentals of our economy were. The day after the now-famous 2006 IMF talk, he went on "Kudlow & Company," on CNBC. Roubini was, as always, the foil to Kudlow's chipperness. "All my friends are in a great mood, Nouriel. They're in a terrific mood. They love America," Kudlow sang. Roubini countered starkly: "Well, they're all rich," he said. "The average American actually is in debt"--a sign to Roubini that housing would only be the catalyst of something larger.

What sets Roubini apart from his fellow economists (and what occasionally gets him in trouble) is his willingness to intuit broad patterns and connect the dots, something that became apparent early in his career. While others spent years refining one econometric model or drilling down on one microsubject, Roubini gorged on a range of diverse topics that, to him, were all related: Japanese public debt, tax evasion, liquidity and exchange rates, monetary policy in the newly formed European Union, the effect of political cycles on industrial economies. As a graduate student, he attracted the attention of older, more established academics both for his ambitiously sweeping econometric analyses and his ability to synthesize vast swaths of seemingly unrelated information. But the first real test of Roubini's eclectic methodology didn't come until 1997. That summer, the government of Thailand--highly in debt and over-leveraged after a long and poorly regulated real-estate boom--cut its currency from its peg to the dollar. Investors panicked, and Thailand's surging economy froze, triggering massive layoffs in real estate, finance, and construction. The crisis, which quickly spread to the rest of the region, took most economists by surprise.

Roubini, by then a young professor at NYU, was trying to stay on top of the rapidly shifting situation in Asia for a class he was teaching. He found it nearly impossible until he hit on a relatively new technology: a website. He hired some students versed in HTML and set up the Asia Crisis Homepage. The bright yellow portal pooled news reports, academic work, and policy debates on the subject, filtering, organizing, and contextualizing the information in real time under no fewer than 32 headings. Wading through the data on Thailand, Roubini found that corruption and bad policy created a vacuum that sucked in a flood of foreign capital. This skewed the country's financial reality and accelerated an unsustainable boom. (Roubini later spotted this distinctive pattern in the United States when the Chinese, Russians, and Gulf states were hungrily snapping up U.S. debt and inundating the market with foreign cash.) But, at the height of the Asian financial crisis, Roubini was, again, in the minority. Many economists saw it as a simple comedy of errors: Misinformed investors panicked, they said, and pulled the rug out from under the Thais. Roubini, on the other hand, saw the crisis as a systemic failure rooted in Thailand's policies. And he was right.

More than a decade later, Roubini-ism--sprawling, non-linear, and hypercaffeinated--looks pretty much the same. His prescient February 2008 blog post that predicted the Rube Goldbergian collapse of the world financial system, for example, was called "The Twelve Steps to Financial Disaster," but, if you include all the sub-steps and sub-sub-steps, the real number is likely twice that. On television, his talking points are similarly pluralized, rushing out quickly, like a magician's scarves, to a grand and logical finale. (At the diner, I clocked him: 295 words on the intricacies of the European monetary crisis in under 90 seconds.) This, of course, means that brevity goes out the window. Roubini's weekly Web column for Forbes comes in at close to 3,000 words and runs at half that length. A recent Roubini academic paper tracks no less than 47 emerging countries over the course of 32 years using more than 50 variables. Giancarlo Corsetti, who was Roubini's advisee at Yale and is now a frequent collaborator, presents with Roubini at conferences, and sometimes finds this expansive approach frustrating. "I go up, I present one or two points," Corsetti says. "Nouriel goes up and gives you twenty-six points, three or four of which are contradictory."

Robert Shiller, who also worked with him at Yale and was one of the first people to warn of a housing bust, isn't surprised that Roubini, of all the great minds staring down our financial future, emerged as the one to piece it together. "A financial crisis needs general thinking, and a team of specialists will have difficulty understanding the whole thing," he says. "Nouriel's approach has always been worldwide, which is not rewarded in academia. There's an element of luck in everything, but it's not random who he is."

This is what the life of a prophet looks like: Two days after we met at the diner, Roubini is back at the airport. He's off on another long jag--four continents, seven countries, eight cities, ten days. He's been thinking a lot not just about the way down but the way out. With the help of the Obama administration's policies (not great, he says, but better than nothing), he sees "a light at the end of the tunnel." To actually get to the end of it, though, the United States will have to get used to consuming less, which means China, Germany, and Japan will have to get used to producing less, which means that all the intermediaries--Chile, Australia, Brazil--will have to scale back and turn inward like everyone else. The world may curve and warp a bit, and it will be difficult, but Roubini sees good in this.

Given the right changes, perhaps the United States can develop with the productive long view in mind, and maybe its human talent can be spread more equitably. "When you have more financial engineers than computer engineers, you know that the brightest minds have gone into something where, probably, the margin was excessive," he had told me earlier. "Maybe some of these bright people are going to do something entrepreneurial, more creative, or go into government. I think that's actually a good change. The transition is painful, but the result may be good." On the other end of the line, I can hear him fumbling with his luggage as he talks, and there's a sense of noble resignation in his tone. He hasn't had any rest since we met, but, he insists, "I cannot get sick. I can't stop." His is hard, life-shortening work, but someone has to tell the world that only its wholesale rewiring will get us out of this.

57 comments:

rapier
said...

Fannie Mae could soon be offering mortgages at a lower rate than Uncle Sam pays.

"The spread between the 10 Yr UST and the 30 Year current coupon mortgage index has collapsed to the tightest level in 2009. If the selloff in 10 Year bonds continues for another 68 bps (at this rate that would be achieved in about 3 hours), it will be cheaper to finance a mortgage compliments of bankrupt Fannie and Freddie, than to issue US Sovereign debt."

Roubini said ..."... etc. ...but someone has to tell the world that only its wholesale rewiring will get us out of this."-----hehehe This blog has been calling it too. The discussions of the consequences are rather lively.jal

You know, you speak of all these things, and you are right. At least you are right where you are. But maybe, Ilargi, you are not there and you can't see what will be because you are not there. At least, not yet. I've no doubt that you will be there one day, for we all will, but you will probably be there sooner than the rest. And so, you keep on making all these predictions based on your analysis and they seem so right, oh, so logical, and they are, they are on the level of consciousness that you are, and you are, yes, above the masses, lucky you! But, yes there is always that butt, for today,it's me, that but, But, what if, Ilargi (and Stoneleigh, I can't really get your relationship to Ilargi, is it friendship? Is it survival? Is is sexual?) What if, there is something more going on in this world that is beyond description? Beyond logic? Certainly beyond the pieces of puzzle that you are trying to put together. Can you even get out of yourself to imagine such possibilities? Or are you so certain? Certainty can only mean death. So certain, of what you write, what you preach, yes, you are a preacher, so certain, that you can not, i.e. cannot entertain the possbility that you are wrong? Dead wrong. Yes, really dead. You are. Wrong. If you only think that you are right, and you do, over and over and over (and entertainly so, I read you every day, so thank you for that!) But what if, and do you even entertain the possbility? I think you do not, that you could be wrong. Maybe, may be, things will not be so linear, as you might imagine. Maybe I am, and so are you, and so is all of life, so much more mysterious, so much more fun that we can even imagine in our linear thinking, and oh, God, yes, Ilargi, you are linear, and you, too, Stoneleigh with biceps, those abs that you think will save you, they will not, and so why push up? Why pull up? And yet, you do Stoneleigh. Don't you? And you too, Ilargi? Whoever you are. Where ever you are. Stoneleigh. She is. Because she knows she is. She is because she had kids and her kids knows she is. Her kids. Her kids are her. And, by God, she knows it. In her biceps. Those biceps are her kid's biceps. Every little muscle. It's not her. It's her kids'. Biceps. Can't I bicep? Can't I bicep life? And so we do. All of us. We skip life. Because sometimes it is easier to bi cep than it is to live it. Really live it. Can you Ilargi? How about you Stoneleigh? How much do you live life? Can you change it one a dime? Can you let go of all you preconceived ideas and just live life? As it is? In all its messy, messed up, cancerous, ugly, imperfect, sloppy ways that it is. And in that messy, messed up, cancerous, ugly, imperfect, sloppy way it is so beautiful, so breathtaking, so humbling. All I can to is bow down before you, before me, before it all, and I accept. I accept me. In all my perfections and imperfections. I accept you. Ilargi. And Stoneleigh. (You're both so great!) in all your perfections and imperfections. And all of your readers, however you may be today, tonight, in numbers low and high, to the few and the far, I know of all your perfections and your imperfections, for I am you, humbly so. And I thank you. For you. For me. And isn't that enough?

I like the theme today Ilargi.I have been sharing info and opinions with a relative who was and continues to be quite bearish on the stock indices. We've been on a Treasury topic recently and he is much more sanguine than I about the ability of governments to issue huge amounts of new debt. He uses debt to GDP ratios as a cornerstone of his thesis for why the US will be able to issue massive amounts of new treasuries without a hitch. GDP:debt ratios were far higher than today immediately after WWII (Britain's was something like 250% in the late 40's). Japan has yet to miss a payment even with a ratio in excess of 180%. Being something of a contrarian he also thinks the extreme bearishness among economists is a sign that the bull market in Treasuries still has its feet under itself. He had some stat that 90+% of financial analysts think that Treasuries are due for a major "correction". Nevermind that that is a no-brainer prediction with how low rates are currently. The ONLY way for them to move is back up. The only debate is about how many months pass before substantive moves up in interest rate, and how quickly those moves will occur.

I think for the near term his logic is sound. I said as much but I said IMHO all bets are off for Treasury notes in 2010. The might be fine, they might suck as a store of value. Hence I am only willing to buy short-term notezs. As you point out, though many people feel pretty tapped out right now because of the losses on their retirement accounts, many (most?) are not yet truly emptied of their wealth. The banksters and politicians still have some juicy targets sitting in retirement accounts, muncipalities' bank accounts, and privately held corporations with little or now debt. What the bankers cannot take with foreclosure the politicians can seize with taxes... I give the Treasury market until at least 2010 before it "dislocates".

Does anyone have the data breakdown on US treasury sales this year? There was a reuters article a few days ago suggesting 8 trillion in issues this year alone. That's nearly twice previous estimates. Where did that figure come from or is it a typo?

"... he [a friend] is much more sanguine than I about the ability of governments to issue huge amounts of new debt. He uses debt to GDP ratios as a cornerstone of his thesis for why the US will be able to issue massive amounts of new treasuries without a hitch. GDP:debt ratios were far higher than today immediately after WWII (Britain's was something like 250% in the late 40's)."

It is so sad.

Mr. Brown's friend (and, it seems, Mr. Brown as well) are not yet clear on the concept. The effort to store value by converting it into T Bills works quite nicely in the short term, but it is also a direct and proactive contribution to the digging of an ever deepening hole into which all symbolic value (money) will one day fall.

Holding such government debt will help sustain the illusion of wealth ( 'rich on paper' ) for a while longer, but eventually that paper's value will go away and you will be left with what?

Moreover, buying government debt sustains that government in power, and literally underwrites the things that government is doing. Are you confident that the things this government is doing will make your future pleasant (or even survivable?)

And one last point. About the ratio of debt to GDP. Of all of the mysterious numbers in the world, GDP has got to take the cake. Gross Domestic PRODUCT" is an almost unknowable figure because somewhere between 10% and 90% of the ostensible money in the world has never shown up on anyone's books as a Product!

Just glance over at the nebulous grand total of 'value' that exists in the form of derivitives. Trillions? Tens of Trillions? Hundreds? Hey, anyone's guess, right?

How much of that funny money got reckoned into anyone's GDP? (pick a percentage between 0 and 100.)

Luckily for those of us alive today (especially those of us past the age of 60 years or so) Rome did not fall in a day. There is yet some time to put your affairs in order.

But please do continue to think about where the so-called 'bottom' of this so-called 'recession' is.

"The very surge in U.S. debt -- the Treasury plans gross issuance this fiscal year of $8 trillion -- means China's heavy buying is increasingly looking like a drop, albeit a very big one, in the ocean....."

D.B. Smith, How do you come up with the statement that I am in favor of holding treasuries? Read the second paragraph of my comment above. I specifically state that I think short-term treasuries will remain a "good store of value" into 2010, but during next year they may well breakdown as such. Hey, I could be off the mark by a mile. I wouldn't be shocked if the dislocation occurs this year, nor would I be shocked if we putter along with fairly low interest rates on gov debt until 2011. My point is that there is still a lot of wealth (even if it is largely illusory) left to draw into government debt.

I agree with your position that buying Treasuries supports the system in its current form, and that it is not conducive to societal health to prolong this system. I know lending my dollars to the US gov just allows us to creep a little deeper into the rabbit hole of craziness, but what would you have me do? I'm trying to find a plot of land/farm to buy, but so far have not succeeded. I will not tie up all my cash in land because I think it would be imprudent to do so at this time.

I can't make heads or tails of that article's claim about 8 trillion in issuance this year. Further down in the same article it says that the Treasury plans to issue 2 trillion in new debt this year. Perhaps the 8 is a mistake?

OK, so the 2 trillion is "net new debt". Could it be that the roll-over period is short enough that the gov has to issue a total of 8 trillion this year, 6 trillion of which is replacement of existing notes, bonds, and bills?

I think the situation might be a bit different, this time. In 1946 the US had come through WWII relatively unscathed and had a great industrial base, as well I think the debt was held mostly internally through things like war bonds, and to top the pudding there was oil for exports as well as cheap oil to run the mechanism. A captive export market along with the mantle of empire had passed from Great britain to the US - the other major powers were either beaten or exhausted after the war. Self assurance and confidence in the future for the US was gang busters, even with the need to restructure from that war time economy to a peace time one. IMO not even as close as that disparate apples and oranges comparison, they guy with the accent talks of.(Do you get that IMG commercial down there too? If not, lucky you, on that anyway!)

Well, I guess I need to start off with an apology, or at least half of an apology. I truly did not believe that you were in favor of holding treasuries. In fact you made it clear that it was your friend who favored the position, and that you were on the opposite side of a friendly debate on the subject.

I say "half of an apology" because it seemed (and still seems) that your view on treasuries is somewhat equivocal, and that you will buy them if there is no better choice when the time comes.

What I was basically trying to say, in a non-confrontational way, is that if an action is ultimately going to have a detrimental effect, then don't do it.

That is my firm position about financing this government's (in particular) shennanigans.

You asked "... what would you have me do?", and I assume that to mean 'What would you have me do to preserve the money I have accumulated, and perhaps make a little more.'

I can think of two things right off the bat. First off, to preserve the funds that you already have (and avoid financing the incestuous affair between DC and Wall Street) you might try what I did.

Secondly, to make a little more money, how about indulging in some good OLD fashioned capitalism? Go out and find some honest and enterprising entrepreneur and bank roll them for a cut of the proceeds?

For example, I just bought a building (for cash) in which a friend will run a re-sale and consignment sale business. Because it was a distress sale and a drop dead price I prearranged with the County to reassess the taxes based on the new price cutting my taxes in half. I sold the building to her at just better than break even, with a quit claim on the deed if she defaults (to protect me), and added a clause to renegotiate the price and terms if the Dollar deflates (to protect her.)

Everybody's happy, and I trust her one hell of a lot more than I trust the current financial system.

In fact, and since all money is essentially faith based anyway, I favor storing value in the form of the willingness of people who I trust to honor an obligation they have to me (and vice versa.) I do not try to 'make money' from my friends. I simply try to preserve a fair portion of it, and help them out at the same time.

Obviously, character judgement is a crucial skill... but has that not always been so?

Any thoughts on the oil price out there? I'm almost back to cost basis for my meager portfolio of oil stocks. It's down a bunch from the boom but I bought in a couple years prior... It's been going nuts the last month or so. With Summer + hurricanes + Mexican export collapse + China's SPR fill-up I don't see an oil crash any time soon.

D.B. Smith, Thanks. It sounds like you've struck up some creative arrangements with your money that will do you and your neighbors/friends well.

Your inference of my question about "what to do" is correct. Although, I'm not really making any money with my holding of treasuries because rates are so low. I hold them because I need liquidity right now and I don't trust many banks.

Part of what prompted me to post on treasuries is the extreme bearishness on them in the MSM and on this blog. I don't like them long term. I just want people to recognize that it MIGHT take another year or so before the expected bond market dislocation takes place.

Soon I'm going to purchase a small farm and set-up to make cheese on a farmstead scale. I have chosen to stick with the Fed's debt because for a while as we (my wife and I) have been unable to decide where to settle.

And so it's clear to all, we do not have all our savings in treasuries. We have some gold, some cash on hand, some treasuries, some money in a checking account. Hopefully inb the near future we will have have less gold and few to no treasuries and the deed to a nice piece of arable land.

Keep those ideas coming. Great addition to the site. But how does one go about finding healthy small banks? A lot of the best and brightest here think that almost all the banks will fail in the next couple of years. For those of us with some liquid assets, and restricting each bank to $10k, that is quite a research project.

Veiled threat of the uniparagraph poster?

Probably just bad acid. Must be a long time reader, not a drive by. Physical conditioning hasn't come up for months.

The coming dislocation should not effect the value of T-Bills of 13 weeks or less. Even Denniger is not predicting an actual treasury default in the near future. As Stoneleigh points out in detail, short term T-Bills are safer than any type of bank deposit. Most banks will fail. Eventually the FDIC will fail. The morality of buying treasuries is another, but valid, issue.

Today's posts got me to thinking about the concept of 'storing value', and that got me to thinking about "Value" itself.

Throughout my life, (the part spent in the USA, anyway) values of all kinds have always been expressed in dollars... including many things that really had no sensible reason to be compared to money to start with.

Love, honor, help, faith, service, respect. You name it and there was a cash equivalent. Character, and worth as a human being were both implied and documented by income and bank balance. Rich was celebrity and poor was pariah.

If anyone needed to 'store value' they did it with money, in one or more of its many forms.

Now its starting to all go back the other way. The wealthy (who need friends, security and happiness in an increasingly chaotic world) are looking for ways to convert it BACK into the things they traded off to get the money in the first place!

Money sure as hell won't buy what they need the most, especially if purchasing power falls to zip.

How fitting. How balanced. How downright poetic.

One of these days it won't mean a tinker's damn how much money one has. What will matter is human relationships and personal character. Do people like you? Are you trustworthy? Do you return favors? Are you brave in conflicts? Dependable in adversity? When working with others are you more usually a help or more like a hinderance?

What if, there is something more going on in this world that is beyond description? Beyond logic? Certainly beyond the pieces of puzzle that you are trying to put together. Can you even get out of yourself to imagine such possibilities? Or are you so certain?

Can you let go of all you preconceived ideas and just live life?

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I actually thought these points and questions were good ones.

I admit I am creeped out by the rest of the stream.

Despite the brilliant analysis by Illargi, it seems that we have shed all signs of reality and no matter if things actually are bleak and banks are insolvent etc., the new paradigm is not beholden to the old analysis.

I guess we can just wait to see if Illargi's predictions for the fall are accurate. If they are not, I wonder if Illargi will admit his analysis did not account for the surreal-ness that he is up against.

Interesting, kinda related, article on Jesse's Cafe:The US Dollar and a Paradigm Shift in the Markets

-el prodigal-

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- Hey anon May 22, 2009 3:40 PM , I din't know ilargi had fall predictions, I must have missed them. Would you let me know what they were or direct me to them? I do know that at some Christmas sometime one will not be able to recognize ones home town. I am already up to speed there and not recognizing my home town already, so if there is something else not to recognize this fall let me know or I might miss it and not recognize that whatever it is is not really recognizable any more. These are getting to be weird days and one must be prepared no matter how weirdly that will become, right? I think I have it right ... please tell me I got it right!

"every single country which has a central bank that issues a fiat currency and charges interest for doing so (think the entire western world) needs a trade surplus at least equal to that interest rate just to play even."

This should create an equal trade deficit with another country that also has a friendly central bank that charges interest on money creation, thus leaving them with increased national debt.

And imagine a global central bank, and global currency, resulting in inextinguishable global debt, with only the owners of said bank making relentless happy profits.

Anonymous 4:21 posted: "This blog certainly has a lot of nutcases. And I'm not just talking about Anon 12:10."

Dear Anon 4:21,

In point of fact, you are not talking at all. To whom (other than Anon 12:10) do you refer?

I see no point to your generalized insult. If some individual has posted something you disagree with, then challenge their facts or reasoning. Why sweep the decks with a broadside of grapeshot? Feeling testy, or just inferior?

D.B.Smith wrote:"Now its starting to all go back the other way. The wealthy (who need friends, security and happiness in an increasingly chaotic world) are looking for ways to convert it BACK into the things they traded off to get the money in the first place!"

You may be interested in this article on that subject:http://online.wsj.com/article/SB124268209889631903.html

Would a rising $C and rising oil price result in lower inflation for Canada?Our best customer, for export, the USA, is not buying so much these days, so it seems that it, ($c), would not have as great an impact on export, as it use to have.jal

....This blog certainly has a lot of nutcases. And I'm not just talking about Anon....

What percentage of Americans believe there is a sadistic white haired old hippie sitting in the clouds needing to be worshipped? You define nutcase please. How many sane humans are there then? Please define sanity.

Yes, Matt is amusing, in a "what??" sort of way. But I can't help thinking an actual grown-up might ask: "how much fossil fuel was burned- shuttling this overweight dude around the entire world- repeatedly? So we can get a nice, totally artificial and mindless warm fuzzy feeling? "

Nightly Summary wasn't thin skinned. Though he immensely enjoyed doing the summary he was spending so much time on it that it was impacting his job and home life. Stick to commenting on things you actually have a clue about.